What Did We See?

• U.S. Large Cap stocks, or the S&P 500 index, were up almost 5% in May.
• The developed markets of Japan, Europe and the U.K. were all up from about 3% to 7%.
• Emerging Markets and Asia (Ex-Japan) were up less than 1% and down more than 1% respectively.
• Global fixed income returns were mostly positive in a continuation of their prior trend.

Where Do We Stand?

• We have now experienced a market rally that expects a perfect recovery of the U.S. economy.
• Valuations have become extremely stretched at the same time the Federal Reserve seems to be pulling back.
• Earnings and unemployment will tell us the real story so it is best to be prepared for all possibilities.
• I remain in a position of avoiding overweights to higher risk areas while maintaining an allocation to large, quality equities.
• I continue to rebalance your accounts accordingly and have been selectively waiting to put more cash to work in portfolios.

The equity markets continued their unexpected rebound through the month of May. At the March lows, equities were discounting an economic collapse. We are now in the midst of that collapse and there’s not much rational expectation for the economy to improve to prior levels until at least next year. Unemployment remains at record highs and economic activity remains stifled at best. Contrary to these facts, the markets have rallied furiously on the actions of governmental leaders, the hopes of a vaccine and hopes for no second wave of the virus. The markets are acting as if the past three months has not really happened. There are several problems with this narrative.

A Quick Fix?

As states and countries try to reopen their economies, there is a very high probability of a second wave. We have already seen this in some places. Remember, we have not beaten this virus. We certainly did a decent job of flattening the curve in most places, enabling our healthcare workers to get ahead. We have not beaten it. Furthermore, out of the dozens of companies developing a vaccine or at least a drug to limit the effect of the virus, the vast majority will fail. This is difficult science. Finding a vaccine may take years, not months. The odds are against us for a quick fix.

But the markets are trading as if the quick fix is already here.

An Earnings Rebound?

More relevant to the near term is earnings and profits. Corporate earnings were already struggling coming into the recession. A quarterly measure for corporate profits for Q1 was recently released and showed a record drop. Only 2 weeks of the Coronavirus experience was included in that reporting period (the last two weeks of March). The next reporting period (Q2) will include most of the entire shutdown plus whatever June may bring. Different than reported profits, reported earnings for Q2 still remain at elevated levels. I have talked in the past about where I would expect earnings for the S&P 500 to come in for 2020. I thought a reasonable level of earnings for 2020 would be $125 with a rebound to $150 for 2021. That now looks rather suspect because unemployment will likely remain higher for much longer than expected.

But the markets are trading as if earnings are fully recovered and growing again.

Main Street’s Pain

Small businesses account for about half of all employment in the U.S. Right now, up to 50% of small businesses are expected to shut down. Local restaurants, stores and shops will have a difficult time navigating the next 12 – 18 months. Many will be forced to close. Many already have closed. This will have a drastic effect upon consumption. Consumption drives earnings and profits. What begins on Main Street will eventually have to be felt on Wall Street. It will take years for those small businesses to come back and the people that worked there to be re-employed.

But the markets are trading as if unemployment will regain 100% of it’s pre-recession levels.

Fed to The Rescue?

Investors have priced in the most perfect recovery any of us could imagine. That leaves much room for disappointment as reality begins to creep into the narrative. When second quarter earnings are reported in July we may get a clearer picture of the economic impact of this virus. Until then we can only marvel at the power the Federal Reserve has had on the markets. With a flood of liquidity and the willingness to do “whatever it takes” the Federal Reserve has effectively drawn a line in the sand at the foot of Wall Street. However the flows are quietly fading. When the Fed announced their initial “Unlimited Easing” in Mid-March they were buying $75 Billion a day in Treasuries, injecting that amount in cash into the economy. That number has shrunk to around $5 Billion a day. At the same time share repurchases by corporations have shrunk to 50% of its 2019 level. We are running out of buyers in the markets.

The Future is Disconnected

So now that we have an idea of what it won’t look like, let’s try to determine what it may look like.

The economic drawdown following the last financial crisis was the worst since World War II. Coming out of the initial shock, the economy operated at 96% of it’s pre-crisis output. That resulted in 10% unemployment after a 50% market correction. Right now the estimate for Q2 GDP is a decline of 9% or 91% of it’s pre-crisis output. We are potentially looking at something that is twice as big as the last financial crisis.

Of course, things are beginning to get better. Activity is picking back up slowly. While that is fueling the market’s rally it misses the major point. Will we be able to get back to at least 96% of pre-crisis levels? If not then we are looking at a recession deeper than the last one.

Only 77% of people recently surveyed on a national level expected to get their jobs back. That puts the country at an unacceptable 9% unemployment level coming out of this. It’s just not enough to warrant a market trading at 90 percent or more of its pre-crisis peak like we see today.

The Fed may pull this off through additional buying programs. They just may be able to bridge the gap between the expectations we are experiencing today and the reality of tomorrow. Thus, it makes sense to keep our clients reasonably invested along most of the targets we have previously established. However, I am not one to turn a blind eye to risk. So we have been decidedly conservative with most client accounts. Cash levels remain higher than normal funded by lower than normal allocations to U.S. Small and U.S. Mid Cap and International stocks.

A Word on Recent Events

The dichotomy of our world has never been more prevalent than it is today. On the one hand we as a nation are launching astronauts from U.S. soil in U.S. built rockets manned by U.S. citizens for the first time in almost a decade. On the other hand we have still not figured out the sanctity of human life and how to protect it.

Our hearts at Shorepine Wealth Management are with all of those who have needlessly lost someone. This is a time when we must embrace our differences and become more inclusive and hence, stronger. No group should ever be targeted for racism, harassment or any other forms of discrimination, ever. We can be better and I look forward to the day when that happens.

If you have any questions or have experienced any changes in your financial situation please do not hesitate to Contact Me.