Disconnect Between The US Economy and The Stock Market

The stock market, for the most part, reflects the condition of the economy. So, if the economy is in a bad shape, then the stock prices will drop and reflect those worsened economic conditions. Mr. Market has this bad habit of predicting the future, while heavily discounting the existing facts at hand. Thomas Carlyle, the famous British philosopher, mathematician, and historian, once said, “Our main business is not to see what lies dimly at a distance, but to do what lies clearly at hand.” In this week’s blog post, I will talk about the disconnect between the US Economy and the Stock Market.

Let’s look at the current condition of the US Economy. As of May 21, 2020, according to Fortune, 38.6 million people had filed for unemployment during this pandemic. That would be a real unemployment rate of 22.5%, just below the 25.6% peak unemployment rate during the Great Depression. Furthermore, according to CNBC, highly indebted “zombie” companies control more than 2 million jobs. The repercussions of the lock-down are evident as companies reduce their earnings forecasts. On the other hand, you have news about how the supply of homes for sale fell 19.7% annually to 1.47 million units for sale at the end of April, and this drop in inventory pushed home prices to a record high. In a way, home prices reaching record high is not surprising since the federal reserve dropped the interest rates, which incentivizes individuals to borrow money (potentially for a home). Pairing this demand up with a drop in supply/inventory will show that home prices were bound to increase. It is important to note that an hourly worker making less than $25/hour is now making more money while he/she is unemployed. Said differently, according to Business Insider, around half of all US workers can earn better pay collecting unemployment than getting regular salaries from their current jobs. Needless to say that this could be the reason why we haven’t seen a big spike in the consumer loan default rate. While regular unemployment benefits last for about 26 weeks i.e. 6 months, the “extra” $600/week benefit will expire at the end of June 2020. As most of the individuals were unemployed in March-April time frame, we could potentially see liquidity dry up come August-September, if those folks haven’t found a job. Interestingly, almost all market crashes happen in the fall, since we, humans, are psychologically trained to be more risk averse in the fall.

Let’s quickly glance back to 1929. This is when Wall Street economy disconnected from the real economy, which started to cool down before the stock market reflected that change. It was evident in summer of 1929 that unemployment had risen, automobile and department sales had fallen sharply, farms across the states were failing, etc. However, the optimism on Wall Street continued until Dow Jones Industrial Average (DJIA) reached its all time peak in early fall 1929. By October 29, 1929, DJIA had dropped 24.8%, marking one of the worst declines in U.S. history. It destroyed confidence in Wall Street markets and led to the Great Depression. Please understand that I am not saying that we are setting ourselves up for another Great Depression. Unlike 1929, the markets in 2020 are heavily influenced by the Federal Reserve and the government. As you might have seen on the news, the Federal Reserve is injecting liquidity into the economy like never before – the Fed is buying everything from government bonds to corporate debt. Furthermore, the government beefed up the unemployment insurance plans and sent a relief check to all qualified individuals. So, I do not anticipate the same level of poverty and hardships seen during the great depression. However, I do want to point out that the same 1928-29 kind of optimism on Wall Street is seen today in 2020. I do not know how long this debt driven speculative bubble can go on – it could go on for a few months or a few years.

As value investors, we focus on the data and facts we have at hand. We know that companies’ earnings have decreased, and are decreasing. Companies are taking on more debt to get through disruptions caused by this virus outbreak. As companies take on more debt, it changes the capitalization structure and makes these companies top-heavy (increased leverage). During favorable economic conditions, the common shareholder of a “top-heavy” company would get a good return on his investment. That same scenario is flipped around as the market conditions deteriorate. As earnings decrease, the “top-heavy” company is still obligated to pay those fixed income charges on bonds and other senior issues; so, the earnings left for the common shareholder might be non-existant.

On Friday, May 22, 2020, DJIA ended at 24,465 points, which is where the index hovered at back in January 2019. Similarly, S&P 500 ended at 2,955 points, which is where the index was back in October 2019. Recall that 2019 was a time when US unemployment was at 3.6% (compared to 22.5% as of May 2020), and the economy was in a fine shape. Back in 2019, companies such as JC Penney, Hertz Rental, J. Crew, Neiman Marcus, etc. had not declared bankruptcies. Lastly, in 2019, airline, cruise, hospitality, and oil and gas industries were operating normally, without any hardships. If you have watched and understand Ray Dalio’s Economic Machine video, you’ll realize how troubles in one specific sector of the economy can disrupt the entire economy. It is amazing how despite all this, Mr. Market values the current market conditions the same as last year’s valuations. I suspect that the Federal Reserve has a big part to play in motivating individuals to speculate and to take the stock market higher, creating a bubble.

One of Warren Buffett’s favorite books is called “Where Are The Customers’ Yachts?: or A Good Hard Look at Wall Street” by Fred Schwed. In that book, Schwed says, “Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort, which should be successful, to prevent a lot of money from becoming a little.” As this speculative “Fear Of Missing Out” (FOMO) market rally continues, I am going to sit on the sidelines. Undoubtedly, just like before, I am still looking for undervalued securities. However, with the current market conditions and valuation, it is more difficult to find the margin of safety I require for my investments. In conclusion, I want to leave you with Ben Graham’s words from the Intelligent Investor, “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.“