May Market Update – Is Unemployment, the Debt and Liquidity Impacting the Market?
May 18, 2020 - Season 3, Episode 3
Since our last Podcast “COVID-19 and the Fear Cycle of Investing” in March, the market continue to be extremely volatile. What is causing this volatility? Are the unemployment numbers fueling investors’ fears? Is the Debt weighing on the Market? And is the Market still overpriced? Chris Abely and I discuss these and several other topics this month.
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Scott Albraccio: Welcome to CTMA's podcast. I'm your host, Scott Albraccio. Here's an opportunity for us to update you on current market trends and conditions and issues you should be considering when investing into your 401k, wealth management plan, or pre-funding.
Today, we wanted to cover several different topics as it relates to the current market that we're in right now. We've been talking to a lot of our clients and getting a lot of feedback from people. And there are some basic questions that people have been asking. I thought this would be a great opportunity for us to go in and address some of them. The unemployment figures just came out and said 30 million jobs have been lost. We knew that was going to happen back in March. Is that priced into the market or can we expect an additional change or adjustment in the market? What's been driving the market? When we talk about liquidity, what are we talking about? And how is that impacting the markets and businesses in general?
Chris Abely, CFA: Let me just start off by saying it's amazing what a month and a half will do as far as the change in things and what's occurred. The last one of these we did, we did about a month and a half ago. And since then, 33 million people have become unemployed. I wanted to talk briefly about three topics. One was the debt that has been taken on and what that's doing, where the market is, as far as how expensive it is or isn't, and then to talk about what it means in terms of unemployment. One of the things that I've got asked the most often is how is it that we could be at such dire straits economically with 33 million people getting on the unemployment rolls? There's a variety of ways that you can talk to and speak to different issues. You can speak to it at a corporate level, you can speak to it at an individual level.
So let's step back and just think about what's happened in the last 60 days or so. In the last 60 days, we've gone from having $22 trillion in U.S. debt to $25 trillion in US debt. It's amazing how quickly that number has grown. We have about $22 trillion of GDP or gross domestic product, which is basically the amount of money that the system generates annually. So we effectively have gone over the amount of money that ... we owe more than we earn. That's a big, big deal.
In the same regard, we have gone from the lowest unemployment rate in modern history in over 50 years to what looks to be the highest unemployment rate when they come out with ... we're doing this on Thursday, May 7th. On Friday, May 8th, they'll be coming out with an unemployment number. And that unemployment number is probably going to be the highest it's been since the Great Depression and probably a little higher than certain times during the Great Depression. So you've got 33 million people who unemployed. 21 million people lost their jobs in April, and that one month is equal to 10 years' worth of jobs.
So we have all of these numbers floating around the federal government had put out $2.5 trillion worth of money to sustain the COVID crisis. The federal reserve and the treasury have put out $4 trillion worth of loans. Those numbers are astronomical. In fact, most people can't get their heads around what those mean. It's understandable why, when you think about it in terms of trillions ... we're used to talking in terms of billions, and now we're talking in terms of trillions.
So how do you connect this to the market? We've got all of these terrible statistics out there, yet the market has been resilient enough to stand up. Well, in a word, it's called liquidity. What is liquidity? Liquidity is basically somebody backstopping the debt of somebody else. As an individual, you would look at liquidity as what do you have in terms of cash? How much cash do you have for the next six months? How liquid are you? How quickly can you get to your investments? For instance, real estate is highly illiquid. Treasury bonds are very liquid. So liquidity is how much cash can you get to and how quickly you can. Well, the liquidity we're talking about was basically backstopping all of the debt that was out there on a corporate level and on an individual level. We went so far as to pay people who are unemployed more money than there actually were making while they were employed.
It's staggering, some of the numbers that are out there. As far as what the ramifications of the longterm are from an economic standpoint, I don't think people fully get it. I don't think the market fully has digested it. The fact of the matter is the market is digested basically that the Federal Reserve is prepared to backstop all debt and make sure that the country doesn't go bankruptcy for lack of liquidity. So connecting all the dots gets pretty difficult except to say that we have got the worst economy in modern history. We've got the market down effectively only about 15% from its all-time highs, and people are wondering, and frankly worried about what is going to happen with the market. So liquidity is something that people need to understand that from their own individual basis, it's the cash that you have on hand, but liquidity in terms of the economy is can you keep it sustainable and can you keep it going?
So look at it another way. If we do $22 trillion worth of gross domestic product, that one year's worth of all of the economic activity in the country, we in effect, with the Federal Reserve, the treasury, and the government, putting more than $7 trillion worth of money in the system, basically paid for one quarter's worth of all of the liquidity that's needed for the gross domestic product. It's staggering what those numbers say.
I think the issue for people is how can the market not be down more than it is? How could the market's still be sustaining itself? Well, in fact, when you think about it, all of this money that's coming to the system, it's had nowhere to go economically because we're not buying goods and services. So it had to go somewhere. Well, where did it go? It went into asset prices, stock prices. So all of that liquidity has been pushed into the market. Now, can the market sustain itself with the liquidity that's been put into it? That's the $64,000 question.
In fact, that's the question that'll probably be answered sometime in June or July of this year, when the unemployment compensation starts to come off. The fact is that how are we going to put 33 million people back to work when hotels are saying that they're only going to be able to have 50% occupancy, where airlines are saying that they're only going to be able to have 50% occupancy, where salons and all kinds of work that's out there is going to be having to be worked at 50% of its capacity?
There's a statistic that you run into that it's called the output gap. What is the output gap? It's the difference between what you can produce and what you are producing. It's kind of like somebody could look at themselves and say, "I can do 40 hours a week, but I'm working 32 hours a week." So essentially I'm at an 80% gap. I'm literally working 80% of my capacity. Well the economy right now is probably at 80% of its capacity. There's an output gap.
So what does that mean and why? Well, it means, as I said, it's the difference between what you can produce and what you actually are producing. But it also means that interest rates are down to zero because there's no demand for money. The demand, it's in a transition state because all of the money that's been put out there has not been able to put into the economics of the gross domestic product or the economics of the system, so it's just sitting out there. And zero interest rates is something that the Federal Reserve is going to have to maintain in order to get us out of the problems that we're in. And that, and probably another one or two stimulus packages from the government, because it's staggering when you consider how many jobs are going to have to come back and how long it's going to take for those jobs to come back.
Scott Albraccio: Everybody's been listening to the earnings report from the companies that are coming out. What is that telling us? Some companies have earnings that are up, some have that are down. What's the impact to the market playing in on that?
Chris Abely, CFA: So there's a classic saying is, "Sell in May and go away until the fall." And what does that mean? That usually means that the market runs up during the March, April and May period. And it runs up for two reasons. One is that corporate earnings start to come out and people get a read of what the economy is doing. And at the same time, we're getting a lot of pension funding, 401ks funded, and a lot of extra cash going into the market. So that actually has happened during this time period, where one of the reasons why the market has been able to sustain itself is because of the excess cash that's going in, but also from some of the earnings that have been coming out, which haven't been as dire as people had expected.
However, the catch here is, is that almost all companies have been saying that they will not project what earnings are going to be. Most of the time companies can have lines of sight into what it is that they expect to do and earn. And what we've found during this period is, is that companies are coming off of the idea of what it is that they expect to earn and how they expect to earn it. So what should we expect? We should expect a lot more volatility in the market.
Volatility, what does that mean? My gosh, some days the market goes up 2%, some days it goes down 2%. It goes up 400 points, it goes down 800 points. It goes up 500 points, it goes down 600 points. People have no feel for what's actually going on. You can see the uncertainty in the prices. Prices change daily to the tune of three or four or five percent for companies that are large capitalization companies, IBM, Microsoft, Apple, you could go on and on, whether or not it's United Technologies, now it's called Raytheon Technologies, GE, all of those companies, the market values are fluctuating sometimes two and three percent in a day.
So the earnings that have come out have been ... well to some degree, two-thirds of them were when the economy was in good shape and one third, which would have been the month of March, was in bad shape. And it's reflecting in company's earnings, but you would expect it to be more reflective in the next couple of quarters, which is why the companies are no longer projecting out what their earnings are going to be and they've taken their guidance off the table.
There's one other thing I'd like to address. As we sit here on May 7th, 2020, the market is actually more expensive than it was in January of 2020. Well, how can that be? The price of the market was 29,000 now and it's 24,000. How can the market be more expensive in May than it was in January? It's simple, the price to earnings ratio, or the projected price to earnings, that is, what the price of the market is versus what the earnings of the market are, is higher now in May than it was in January when people are saying, should I get in the market? Should I not get in the market? You always have to be cautionary when the market is so high priced.
Now, some people may argue that it's high priced because people expect the earnings to rebound rather quickly. So in terms of price to earnings so that you understand why it's important, think about it in terms of yourself. It's like, can you afford the house that you're in, basically saying, if I make 50 or a 100 thousand dollars a year, what kind of house can I afford? I can afford a $250,000 house or a $300,000 house. So basically what you earn versus what you can buy is essentially what a price to earnings ratio is. It's what you earn versus what you're worth.
And you do it off of a lot of different definitions. You could do it off of net worth, you could do it off of price to sales, lots of different things. But the corporate vernacular, the vernacular of investing, it's called price to earnings ratio. And that's where people measure things just so that they could get relative value off of something that was in the past versus today, and then what's something in the future versus something in the present. You need to make sure that you prepare to take the risk of that. If the earnings don't rebound quickly, then you could see another leg down in a market where the economics continue to be more dire than people expected them to be.
A month ago, you would have never thought that you would have heard from the airlines that they were putting plastic partitions between seats. The middle seat's going away. Anybody who flies know that they're just ... that's a fabulous thing that the middle seat has gone away, except it's not so fabulous when you think about the economics of it. How can a restaurant operate itself at 50% capacity? How can a salon be wearing masks while they're trying to do things for their clients? I think that people didn't understand how dramatic life was going to change.
Now, the next step is we'll have a vaccine and it'll happen soon. I think that might be what the market is betting on, which is why it's not down more than it is. But all of those things are risk. Trying to see through the risk of something usually requires you to measure it and understand it. It's tough to measure and understand when a vaccine may come along.
Scott Albraccio: So do we want to address the fed and their willingness to go back in and purchase investment grade and/or high yield corporates? It was a statement that Powell made at his last press conference.
Chris Abely, CFA: The Federal Reserve, as everybody knows, is the bank of the country. It's the lender of last resort. And what does that mean? That means that the last person to go is the Federal Reserve. So what has the federal reserve done in conjunction with the treasury? They have come in and said that they're going to lend $5 trillion into the system. They went so far as to say that they would buy junk bonds, high yield junk bonds. You would have never, ever thought in your wildest dreams that the Federal Reserve would be buying junk bonds.
Never would you have thought in a capitalist country that they'd be buying the equity of major industries, be it the airline industry, be it whatever other industry that they're going to have to be buying the securities of. Well, that's what happens when you get an economy that's so interrelated that things can go in an instant. So what is the Federal Reserve doing? In order to keep the economy going is basically buying and being the lender of last resort in the biggest capacity that they ever have been. They're also making sure that interest rates are going to stay as close to zero as long as they can. What should that do? Well, that should cause inflation. And that's a conversation probably for the next time we have a podcast.
Scott Albraccio: Where should investors today be looking or focusing in terms of investment? We've got people investing in 401ks. You've got people just investing in general assets in the market because they can't put them anywhere else to get a rate of return at this point in time. What would be a sector or an area for somebody to look at?
Chris Abely, CFA: Often I get that question about how come the economy is in one place and investments are in another place? And then the next question that comes up is where should I invest and how? Well, sometimes you should invest in safe assets and allow it to be what it is. Sometimes you shouldn't be caught talking about investing, you should be talking about saving. Sometimes you should be talking about making sure you preserve your principle versus trying to go for a high rate of return. And some times you have to look at your own personal situation and say, "How much liquidity do I really have and how much tangible net worth do I really have," and say to yourself in a realistic perspective, "Can I afford the risk associated with having the volatility in my portfolio so that one day I can be 3% richer, the next day I can be 10% poorer?"
The truth of the matter is, is that people need to see risk for what it is as opposed to investment and where should I be investing? Which doesn't mean that as a professional, we don't have places that we can put money and invest money. It does, however, mean that when somebody is talking about where should I invest and what should I invest in, they need to make sure that they still frame the idea of are you saving money? Do you have tangible net worth? And where can you afford to invest? Sometimes those questions are more important than what should I invest in because the natural answers to those questions will get you to what you can invest in. That being said, there's still value out there. There still are companies out there that are paying very nice dividends and have solid balance sheets that you can invest in. That's boring investing. That is however, what we believe is the right strategy at this point.
Scott Albraccio: One of the things that you just covered, and it's been in all of the trade presses lately, is the fact about people having enough in terms of savings. And there's been no truer time that that's been a call to arms where people should have at least three to six months worth of emergency savings set up to be able to get through a situation like this.
Chris Abely, CFA: What is amazing is that corporations didn't save for a rainy day, which is the reason why the Federal Reserve has had to be the backstop in so many different places. Companies leverage themselves, bought their stock back, put themselves in a position where they didn't have solid balance sheets. Now, you could make the argument that they had no choice because that's where the market was and the market forced them to go in that direction. Individuals, when they get too leveraged, they don't have the same ability that companies have. So if they don't have savings, they can be in a predicament that causes them to have very dire consequences. Anybody who lived through 2008, 2001, 2002, 1990, 91, 1987, knows full well that you need savings because unintended things occur, things that you didn't see coming occur.
And let's face it. We're not all in control of our lives when we think about where we get our monies from. If we're getting our monies from a certain work that we do, that means we're relying on a lot of other things to make sure our lives are whole. And when you rely on a lot of other things to make sure your lives are whole ... and by that, I mean you need to buy your gas from somewhere. You need to buy groceries from somewhere. You need to be able to live your life. It requires you to have savings. And sadly, I think over the next six months, we're going to find there's going to be a lot of terrible things that occur for people who, when the unemployment benefits run lower, their mortgages still have to be paid, their kids have to eat. We're going to find that we're going to have to redefine some of the rules as to what is and what isn't helpful for people. So savings versus investing.
Scott Albraccio: One other thing is that we've been talking about the bailout, if you will, or the treasury and the fed putting trillions of dollars out into the marketplace. The question is, in some aspects of it, these are forgivable loans if you will, if employers follow the rules set forth by the CARES act or PPP. How are we going to service this debt? Are we looking in the long run of increased taxes? Are we actually going to fund our own bailout in some respects?
Chris Abely, CFA; So if you look at debt from an individual's perspective, everyone knows that you have to pay it back, that you can't just continue to roll it over. Well, in terms of the US government, they have been able to continually roll it over. However, at some point, you need to start to pay back the debt. And when the debt starts to get paid back, a couple of things are going to occur. One is you're going to have a lot slower growth, if you're going to have growth at all. Two is somehow you're going to have to get that money from somewhere. And where's it going to come from? Well, it's either going to come from a decrease in spending or an increase in revenue or some combination thereof. So the government went from $22 trillion in debt to $25 trillion in debt in a month.
Do we have to pay that back right away? No, but there is something called Social Security and Medicare, and there is something called the baby boom generation. And it is growing right into the social security and Medicare. So of the $25 trillion that the government owns, six trillion of it is to ourselves. Now that means that we're going to have to pay out to social security and to Medicare six trillion dollars. Well, you can't not pay that money. It has to be paid somehow in the form of services. So it is very difficult to see that there aren't long term consequences associated with what's just happened. And it's not just a wipe the slate and it's one and done.
So the other question inside of that question was corporations that are borrowing money now in order to sustain themselves. They're going to have to pay that money back. Now, are they going to pay it back in the form of taking out more equity? Are they going to pay that in the form of trying to find another way to consolidate their debt? There's some combination there that's going to occur, but what happens when you borrow money and you have to pay it back, is your future is less by the fact that you have to pay it back.
Anybody knows if you have savings, you are much more flexible than if you have debt. Just to put a finer point on this, in 2018, when the Federal Reserve decided that they were going to start to try to pay down their balance sheet from the last crisis, which was 2008 ... in 2008, the Federal Reserve took their balance sheet from $800 billion to $5 trillion. They decided they were going to start to pay some of that balance sheet down. Well, that's when the market went haywire and in fact, the Federal Reserve found out that they can't pay that bad debt down. The market can't absorb it. So now they are basically doubling the size of their balance sheet with basically bad debt, and how are they going to get it off their balance sheet? That remains to be seen. In fact, you could make the case that we are in the 1930s and some of those decisions are going to be made from a class system who should be paying off and why.
Scott Albraccio: One of the issues a lot of the employers are having right now, you're talking about food service and having every other booth open or every other table open is bringing people back in where they can make more money staying at home. But what they don't realize is that the federal stimulus is going to end, and they're not going to get that extra $600 that they were getting. So it's ultimately going to come back down to where they can't live on unemployment alone. They're going to need to go back to work.
Chris Abely, CFA: In finance, there's a thing called helicopter money, that is, money that gets basically dropped from a helicopter and it's free money. Well, anytime anyone has experienced something that's free knows that the value attached to it is relative, especially when you have an abundance of it and it's free. You take a much more nonchalant view of it and you end up where the economics are distorted. How long are they distorted for? Just long enough for the free to wear off.
So there's two instances where this is happening right now. One is with the PPP, which is the Payroll Protection Program, where companies are getting money to fund their payroll and to fund their operating costs for an eight week period of time. That actually may turn out to be a very productive thing, because most of the time, people who are in business for themselves understand that capital is something that needs to be invested. So there may be a very good thing there that the capital gets invested, maybe planting equipment, or just to be able to survive this traumatic time. That may actually turn out to be a very good thing.
The consequence of being paid more not to work than to work, I think that that's a separate one unto itself. If somebody's getting more in unemployment than they're getting to be employed, the individual is probably going to make the decision to stay home. After all, from an economic standpoint, they're better off. But what are the longterm consequences of that? Think about the debt that we're taking on to pay people not to work. It also will probably slow the rate of growth. It'll slow the rate of attrition back into the workforce, and it may be at a position where the employers who need to get their people back to work can't get them back to work.
Scott Albraccio: Thank you for listening to our podcast. I hope you found that informative. Don't forget to subscribe to our channel and never miss an episode.