Updated: Sep 15, 2020
Dear Clients and Friends,
Sit back and settle in, because this week’s update is a long one. We’re going to present a simple layperson’s update on the health-related issues of COVID-19, as well as a recession forecast update. In addition, we will describe why we think the current stock market level is unsustainable, as well as offer a hypothesis regarding why the market rebounded following its mid-March low. This update may at first sound encouraging, but as we correlate our social situation to our economic condition, it may begin to sound otherwise. Let’s dig in.
I want to thank Brad McMillan, whose research we often use and have quoted below. We’ve also collected mountains of data from the Federal Reserve Bank of St. Louis, Thompson Reuters, and several other providers in order to prepare this update.
First, let’s talk about the current COVID-19 situation and the progress that we’ve made.
You can see from the chart below that, in that time, the new case growth rate has declined from about 5 percent per day to the present level of less than 2 percent per day. Put another way, the number of new cases went from doubling in about two weeks a month ago to doubling in about seven weeks now. This shift represents significant improvement—we have succeeded in flattening the curve even further at a national level.
Source: Data from worldometer.com
Daily testing rate. We have also made further progress on testing. The daily test rate is up from just about 150,000 per day in the middle of April to 300,000 per day and more in the past several days. While this level is still not where we need it to be, it represents real progress.
Source: Data from the COVID Tracking Project
Positive test results. Another way of seeing this progress is to look at the percentage of each day’s tests that are positive. Ideally, this number would be low, as we want to be testing everyone and not just those who are obviously sick. The lower this number gets, the wider the testing is getting. Here again, we can see the positive level has halved from the peak. More people are getting tests, which means we have a better grasp of how the pandemic is spreading.
Source: Data from the COVID Tracking Project
New cases per day. As a result of these positive developments, the improvement in new cases per day is also substantial, down from 30,000 to about 20,000. And this number is even better than it looks. With the wider range of testing and the number of tests doubling, other things being equal, we would expect reported cases to increase in proportion to the number of tests. In fact, we have seen the number of daily cases ebb and flow with the testing data. Overall, however, the trend is down.
Source: Data from worldometer.com
Total active cases. The real news this week is that we are just about into phase 2, as we move from controlling the spread of the virus to starting to bring the number of active cases down. On May 12, with a combination of lower new cases and higher case resolutions, we saw the number of active cases drop for the first time in this pandemic. While that trend may not hold in the short term, the fact is that the active cases are stabilizing. This stabilization is the essential first step in taking the number of active cases down to zero—which is the phase 2 we are now approaching.
Source: Data from worldometer.com
We are getting close to controlling the coronavirus pandemic and even approaching a point where we can start to close it out. While we are not out of the woods yet, we are at the end of the beginning of the process—and moving in the right direction.
Economic damage may have already peaked
Job market. While layoffs continue, there are signs that the damage may have peaked and has started to recede. Weekly initial unemployment claims continue to decline from the peak, suggesting that much of the damage has already been done.
Even better news is that the continuing claims number (i.e., those who received unemployment from previous weeks) increased by less than half a million, even as millions more lost their jobs. These numbers suggest that as the economy reopens, almost as many people might have returned to work as have lost jobs during the past week. Between the federal programs protecting employment and the reopening, jobs appear to be having a faster rebound than expected, which should have a significant positive effect going forward.
Federal stimulus. With the job market damage moderating, the federal aid is also mounting. As you can see in the chart below, the federal stimulus programs are now putting substantial amounts of cash into the economy. These funds should keep mitigating the damage and encourage the reopening.
Source: Wall Street Journal Daily Shot
Risks remain. Although the reopening is going better than expected and is clearly having some positive economic effects, we certainly face risks as we reopen. The biggest of these is a second large wave of the pandemic. Reopening means loosening the social-distancing restrictions and exposing more people to infection risk, which could certainly inflate case counts. We have not seen that increase yet, though. If people continue to do things like wear masks and maintain distance, that additional case growth might be acceptable. That will be something we will learn, and it seems probable that most people will act in a safe manner. The real test will come in two to four weeks, when any new cases arising from the reopening will start to show up. So, we won’t really know about that risk until then.
Another potential risk is that, even with the reopening, consumers will be slow to return and spending growth will not return to what was normal any time soon. This outcome seems probable, especially in the early stages. Here again, spending growth is something that could end up doing better than expected. But early data shows that spending recovery has been fairly slow; if it continues to be slow, that will be another risk to the recovery.
Markets have started to reassess
For the financial markets, these risks are starting to come into focus. Until very recently, the reopening was a ways away, and the markets’ assumption was that the reopening and recovery would go well and quickly. Now that the reopening is underway, markets are reassessing those cheerful assumptions, and we are seeing some volatility. That volatility is likely to continue over the next several weeks, until we get some data as to how bad a second wave of infections will be and how consumers return to spending. The good news is that when we get that data, markets will have a much firmer foundation.
The real takeaway
The real takeaway from this past week is that progress continues, to the point that reopening now looks quite possible. We are not yet out of the woods, and there are certainly significant risks going forward—with a second wave of infections being the biggest.
While our progress against the disease is real, the economic impact of the pandemic has been distressing. Roughly once per month, we provide a market risk update or an economic risk update. Today, we will focus on US economics. Our monthly risk updates provided in part by our good friends Brad McMillan and Sam Mellette utilize a traffic light approach: green, yellow, and red. I’m sure it won’t surprise anyone that all of the lights are red at the present time.
The economic data releases in April continued to highlight the devastating effect that measures to combat the coronavirus have had on the economy. While some of the individual reports came in above expectations, those results were due to sharply lowered forecasts rather than better real economic outperformance. All of the major economic indicators we follow in this piece are now at a red light level and are likely to remain so for the immediate future. We are quite likely in the midst of a recession, and the worsening data highlights the very real damage that has been done to the economy over the past two months.
In this edition of the Economic Risk Factor Update, we have extended the time frame in the charts to include the collapse in 2008. This extension provides valuable context about the depth and timing of the current downturn, and it will provide some guidance once the data starts to turn more positive.
The Service Sector
Signal: Red light
This measure of service sector confidence fell by less than expected during the month, declining from 52.5 in March to 41.8 in April, against expectations for a larger fall to 38. Despite the better-than-expected result, this drop brought the index to its lowest level in more than a decade and close to the nadir during the last crisis, as service sector confidence now sits near the all-time low of 37.8 set in November 2008. This is a diffusion index, where values below 50 indicate contraction. So, this drop is concerning, although not necessarily surprising given the shutdowns to most businesses during the month. Going forward, the declines we saw in business confidence during the month are a bad sign for future business investment, which was already weak heading into 2020. Given the continued weakness in service sector confidence, we are leaving this indicator at a red light.
Private Employment: Annual Change
Signal: Red light
April’s employment report showed the devastating impact that wide-scale shelter-in-place orders had on the jobs market, with 20.5 million jobs lost during the month. This result was better than economist estimates for 22 million lost jobs, but previously released unemployment claims data indicates that this report may be undercounting the full extent of the damage. Despite the better-than-expected results for headline job losses, April represents the worst single month for American job losses since the Second World War. Given the historically bad result for headline jobs during the month, we are keeping this indicator as a red light.
Private Employment: Monthly Change
Signal: Red light
These are the same numbers as in the previous chart but on a month-to-month basis, which can provide a better short-term signal. The pace of month-over-month job growth dropped sharply in April, with the number of jobs falling by more than 15 percent. This drop represents the largest monthly decline since records began in 1939. The underlying data was also weak, as the unemployment rate increased to a post-war high of 14.7 percent, against expectations for an increase to 16 percent. This brought the unemployment rate well above the recent high of 10 percent that was seen during the great financial crisis, and there is evidence that misclassification of some workers kept the reported unemployment rate artificially low. Given the massive disruption to the job market in April and anticipated future headwinds, we have kept this signal at a red light.
Yield Curve (10-Year Minus 3-Month Treasury Rates)
Signal: Red light
After spending the fourth quarter un-inverted, the yield curve briefly re-inverted in January through February, un-inverted again in March, and remained un-inverted in April. This un-inversion was driven by a sharp drop in short-term rates, which in turn was caused by the Fed’s decision to cut the federal funds rate to effectively zero percent in March. The yield on the 3-month Treasury remained largely range bound in April, falling from 0.11 percent at the end of March to 0.09 percent at the end of April. The 10-year yield also declined slightly during the month, down from 0.70 percent to 0.64 percent.
While an inversion is a good signal of a pending recession, it is when the gap subsequently widens to 75 bps or more that a recession becomes imminent—which is what happened in 2008 and what has just about happened again. With the spread near the critical level, we are leaving this indicator at a red light. In conjunction with other monetary and fiscal policy actions, the current spread levels clearly represent a risk.
Consumer Confidence: Annual Change
Signal: Red light
Confidence declined from a downwardly revised 118.8 in March to 86.9 in April, a drop of 31.9 points. This drop, which was worse than the expected decline to 87, represents the worst monthly decline since oil was embargoed in 1973. On a year-over-year basis, confidence declined by roughly 32.7 percent. This disappointing but unsurprising result brought the index to its lowest level since 2014.
The decline in headline confidence was caused by a sharp drop-off in the present-situation subindex, which fell from 166.7 in March to 76.4 in April. Given the unprecedented number of layoffs over the past two months, as well as the continued efforts to combat the spread of the coronavirus, weak confidence is expected going forward.
This report bears watching, as hopes for a V-shaped economic recovery will likely hinge on a swift rebound in consumer confidence and spending figures. At the moment, the annual decline is well below the 20 percent that historically has indicated a recession and is unlikely to recover any time soon. Given that gap, we have downgraded this indicator to a red light.
Conclusion: Economy likely in recession
While some of the April releases came in slightly better than expected, these outcomes were primarily driven by cratering economist expectations rather than a meaningful pickup in economic activity. The overall picture is of an economy that is turning down sharply from the headwinds created by the current anti-coronavirus measures. This is a swift change from the first two and a half months of the year, where we saw largely improving economic data. These earlier results helped cushion some of the initial fall in economic activity in March; however, the worsening fundamentals in April point to a continued slowdown until further progress is made in containing the coronavirus and returning closer to pre-pandemic activity levels.
Ultimately, this was a month that showed quite clearly the full impact that a large external shock can have on the economy. Both on a monthly and year-over-year basis, the reports point toward an economy that is likely in the midst of a recession. Given the weakening economic fundamentals during the month and the anticipation of further pressure from the measures to combat the coronavirus, we are leaving the overall risk level at a red light for the economy as a whole for May.
Things are bad. There is no doubt about it. However, the market recently experienced an astonishing rally following its March lows. For context, let us compare the current market level to the fourth quarter of 2018. The chart below shows how far the Dow Jones Industrial Index has fallen from its previous high at any given time over the past two years. During the fourth quarter of 2018, the Index fell roughly 19%. As of the market’s close on Friday, the Index has also fallen about 19%.
I’ve asked many people if they remember the drop in 2018, and most do not. Those that do remember it can’t recall why it happened. I believe that the reason most people don’t recall the event is because there wasn’t really any reason for it. The market wobbles sometimes, and the wobbles are often dramatic. But how is it possible for the market to be at a similar level today as it was in the fourth quarter of 2018, given the challenges that we are currently facing?
I’ve cherry-picked a few charts to illustrate how dramatic the current situation is. Below we see a chart of retail sales month over month, which is followed by a chart of weekly jobless claims. The effect of 2008 is visible in both of these charts. But if we compare 2008 to the COVID-19 crisis, the great recession looks like a mere blip on the radar.
There are only two possible reasons why the current market level could be considered rational: 1) there is an expectation that the economy will return to normalcy within the next few weeks, or 2) the economic stimulus is sufficient to carry the US economy for several months or several years. Having reviewed polling data, we think that a return to normalcy is almost impossible. The stimulus, while significant, will not suffice if a second wave occurs, or if the economic recovery is mild and slow.
A lot of consumption demand has been lost rather than delayed. Those looking forward to their monthly haircut will not request 3 haircuts in the next 30 days just because they missed their last two. We read reports that the airline industry will take 3-4 years to recover. While there are industries where the demand has been delayed rather than lost, they are in the minority. Thus, we believe that consumption will be muted once it resumes. In addition, we are reading reports of employees who return to work and then choose not to return on day 2 or 3 due to fears of contagion. I must assume that many people will chose not to dine in crowded restaurants even if they can. It will be the same for virtually any storefront, especially if a second wave emerges.
How did the market recover so rapidly in spite of this grim outlook? In mid-March, the Vickers insider-trading index showed the highest buy/sell ratio among corporate executives that we’ve ever seen. This means that CEOs, COOs, etc. were gobbling up their own shares at a historic rate. This was likely happening because, without decent data regarding the coronavirus, executives were dismissing the health-related issues of the outbreak and recognizing a seemingly terrific entry point at which to buy their own company’s stock. This was the first stage of upward momentum.
We also saw historic amounts of money from foreign countries flowing into the US. While domestic investors became fearful of the stock market, foreign investors (especially those in emerging markets) sought safety by moving money into the US stock market. More momentum.
401k’s tend to be indicative of retail “main street” investor behavior. During the month of March, we saw one of the largest swaps from stocks to bonds in history. In April, we saw one of the largest swaps back - from bonds to stocks. This is an unfortunate example of selling low and buying high, but it certainly added to the market’s momentum.
Finally, we see news-related “selection bias.” Selection bias is a cognitive bias that occurs when data is selected for analysis in such a way as that proper randomization, accuracy, or context is not achieved. For example: initial jobless claims were down 50% last week from several weeks ago. Good news, right? Except that claims are down to 3 million per week from 7 million. Until 2 months ago, 3 million initial jobless claims per week was a record of epic proportions, a record multiple times higher than the previous record. This “decrease” in initial jobless claims seems to have gathered as much attention as recent bankruptcies. Neiman Marcus, JC Penney, and Lord & Taylor are three retailers that have been around for generations, and all have declared bankruptcy within the last few weeks. Yet with jaw-dropping amounts of people filing for unemployment and three huge retailers going bust, the headline that mattered was about decreasing amounts of jobless claims.
As trading volume has decreased over the last two weeks, the market has lost a lot of support. It appears that the market trends up on days with a high trading volume. However, the market falls in the absence of such surges. That supports our belief that, underneath the selection bias and the hope for a rapid economic recovery, the underlying market sentiment is negative. Additionally, protective option contracts are very expensive right now, which indicates that a lot of people are willing to spend a lot of money to protect the value of their portfolios from a dramatic downturn.
Ok, I think we need to wrap this up because this was a lot to absorb. Thus, here is the summary:
Substantial progress has been made with the virus, and that’s terrific.
The economy is in very bad shape - not so terrific.
The market levels appear to be totally illogical.
We believe we understand why the recent rally occurred.
We doubt that the rally is sustainable.
Therefore, we remain extremely cautious and underweight risk assets.
Although we have had a high rate of success in predicting substantial market movements in the past, we can’t always be right. We do not have a crystal ball. Admittedly, we could be wrong about our bearish sentiment. However, we feel extremely confident that the reward is not worth the risk of loading up on risk assets at these levels. If we miss 10%, or even 20%, on the upside, it is not worth the possibility of suffering a 30%, or even a 50%, loss. We began “de-risking” in 2019 and again at the start of March. It was a good call. We are not ready to redeploy.
With that, let us know who read this entire article. Winners get a treat by answering these questions: What is 2435 squared? And what is the significance of the number 2435?
We wish all of our dedicated readers a wonderful and safe week.
Lots of love,
-The entire MORWM family
Matthew Ramer, AIF®
Principal, Financial Advisor
MOR Wealth Management, LLC
1801 Market Street, Suite 2435
Philadelphia, PA 19103
P: 267.930-8301 | c: 215-694-4784 | f: 267.284.4847 |
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Vero Beach, FL 32960
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The majority of this content was written by Commonwealth Financial Network®. Distributed MOR Wealth Management, all rights reserved. Securities and advisory services offered through Commonwealth Financial Network, Member FINRA/SIPC, a registered investment adviser. Fixed insurance products and services offered through CES Insurance Agency.
Securities and advisory services offered through Commonwealth Financial Network, Member FINRA/SIPC, a registered investment adviser. Fixed insurance products and services offered through CES Insurance Agency. Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. As stated above, commentary for the 5 risk factors provided by Brad McMillan and published in the Independent Market Observer. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. The S and P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index. The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.