What is happening? Does anything even matter?

Highest levels of unemployment since the Depression and stocks go up.  Terrible GDP print numbers and stocks go up.  At the same time companies are laying off people, banks are seeing distressed borrowers and there are cracks in the economy.  It's really hard to reconcile what's happening in the stock market with what's happening in the economy.

It's been said that the market is forward looking.  It's also been said that it's fully efficient.  And I've also heard that subprime is fully contained.  That last statement was a joke if you were investing before the Great Recession.

One good thing about a market climb while our country is facing generational economic devastation is that it shows that investors are optimistic.  I believe that ultimately outcomes are built on perspective.  If one mopes through life they will experience less fulfilling outcomes than one who is eager for what lies ahead regardless of the difficulty.

I'm just as biased to optimism as anyone else.  I badly want the virus to go away, for everything to return to "normal" and for life to continue as if this never happened.  But is that realistic?

Most of life is built around narratives.  People form narratives to help them understand what they're experiencing and what they're seeing.  Most of these narratives are formed through first hand experience.  If commentators on TV are proclaiming a recession but "all my local stores are full" one might create a narrative that "things aren't too bad."  Conversely if one sees "Closed for good" signs on all their local stores they might form a narrative that a recession is severe.

These narratives drive our lives, and they drive the market.  In 2008 the narrative on Wall Street was that the sky was falling.  Why was this?  To start with Wall Street itself was affected.  Investors saw large banks closing, a frozen bond market and they dumped equities.  This time around Wall Street seems untouched.  Banks aren't failing, and hedge funds aren't closing, so investors seem to have formed a "how bad can it be?" narrative and bid up stocks.

Yet outside of markets the real economy is acting like investors did in the fall of 2008.  Companies are looking forward and slashing people, expenses and any line item as quick as possible.  They don't see a quick return to normal, they see a period of depressed revenue and depressed earnings.  They're doing what they can to survive.

One company's capex is another company's revenue.  It's a vicious circle.  With each cut in capex another company might have to cut employees.  This isn't the type of cycle that reverses quickly, it takes quarters if not years before companies gain confidence that revenue is here to stay.

All of this cutting, revenue, expenses, employees has the potential to lead us into a deflationary spiral.  If company's don't have confidence in their revenue they will spend less on people and goods.  If there is less demand for goods prices start to fall.  As jobs are cut demand shrinks for consumer goods, and prices get cut in an effort to attract demand.

While the real economy appears to be deflating we still haven't seen deflation in the market.  It's likely that's coming next.

In 2008 I was working for a telecom company.  As the market fell apart life went on like nothing was happening.  The company eventually hit a speed bump because they were debt financed and they struggled to get a bond deal done.  But outside of that nothing really changed.  Co-workers would discuss how horrible headlines were, but it didn't hit us directly.

Eventually after a barrage of bad headlines this telco started to get worried.  Their actions lagged the market.  In 2010 they were still worried about "the crash" and things coming back.  But by that time the market had raced forward.

It's my speculation that something similar might happen now, but with the real economy leading the charge and the market lagging.  Investors are expecting a quick bounce.  The reason for this is as everyone is stuck inside it's really hard to build a narrative.  Instead of building narratives from what people are seeing day to day they're building a narrative based off headlines and optimism that things are almost over.

I think a possibility is that the market is going to be shocked when companies don't turn around quickly in a quarter or two.  And then a quarter or two later will be even more shocked that things are still depressed.  By that time investors will have lost faith and sold out of stocks.  While at the same time companies might be seeing green shoots and things might be turning. 

The question is "what's an investor to do?"  I don't know, but I can tell you what I'm doing.  I came into this whole thing with about 50% in cash.  As stocks fell in March I deployed some cash into bargains as I saw them.  I've also shorted companies that look like they're on the brink of disaster.  My thought is some of those shorts can be cycled into even cheaper names if stocks ever fall again.

But what happens if they don't?  Let me make a wild and unsubstantiated speculation about that.  I think if stocks keep climbing while we experience Depression level economic measures that it could be the breeding ground for civil unrest, or some sort of dark horse politician who imposes punitive taxes on wealth.  I hope this doesn't happen, but the foundation for it already exists.

Ultimately though if I'm reflective on this whole thing I want to stick my head in the sand like everyone else and hope things turn out better on the other side.

Until we get there, stay nimble, and stay healthy!

1 comment:

  1. This post resonates so well with me, I don’t even know where to begin.

    A bit of context: First, my family owns a small business in the SE, offering a myriad of services to auto dealers. It’s been around for a long time (41 years), and it’s seen its fair share of economic vicissitude. We haven’t been this worried for a very long time. Our customers (dealers) are down on sales from anywhere from 1/3 to 6/7 (!), with the larger groups suffering the most. And on the other hand, in the used oil market, a total regime shift has emerged (see here: http://www.imo.org/en/MediaCentre/HotTopics/Pages/Sulphur-2020.aspx & here: https://ir.cleanharbors.com/news-releases/news-release-details/clean-harbors-announces-increases-used-oil-pricing-and-service?field_nir_news_date_value[min]=). Note that the marine market accounts for roughly 6/10 of the total re-refined oil market, so a sulfur reduction by about 6/7 is going to permanently and negatively impact resale. Anyhow, this is to say there’s a lot of headwind in the business and likewise in all similar vendors to automotive dealers.

    Second, my wife’s family owns a commercial retail real estate operation, and suffice it to say, they’re very worried. For weeks now, she’s done nothing but work out amendments (concessions) to their tenants. Everyday she tells me about another handful of tenants that’re struggling and what measures they’re taking to avoid putting them into default. And of course, all deals that were on the table, are now either tabled or completely off-the-table. So again, it’s nothing but headwinds.

    Now obviously commercial real estate & autos have been hit hard in particular, but I say all this because it adds to the real economic narrative of which you speak. That is to say, real businesses are really suffering. The “real economy” is very forward indicating in relation to the seriously lagging “market economy.” It’s a total inversion of standard academic finance & the notion of the market as a forward discounting mechanism.

    The bit about deflation though, I wonder to what extent the macro developments per the fed & the fiscal stimulus (stimuli now) are offsetting this forward deflation with their present inflationary actions?

    Now, in sum, my perspective is similar to what was said about a quarter or two out: the market will potentially be incredulous as to the state of the real economy as it’s revealed. Of course, as it was also said, it is a possibility that another downturn could be avoided through the sustenance of an optimistic narrative. Namely, that even as the underlying economic destruction is uncovered nothing but “green shoots” are seen by Mr. Market.

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