The economy is dying but the markets seem to be living large

The International Monetary Fund predicts 2020 to be the worst downturn since the 1929 Great Depression. 
The Minneapolis Fed says unemployment rates could surge to Great Depression levels.
Barron’s News & Finance said, “perhaps it’s better to think in terms of biblical disasters.”

So why do markets not seem to be pricing this in?

Many people see an upward trend on the stock market and think that the economy is going well (despite the anecdotal evidence of millions of people out of work and thousands of closed shopfronts).

To gauge a clearer picture of stock values, I like to compare them to property and bonds by doing simple division. We divide the price of the asset by the income it is bringing and get an answer to the question: “How many years do I need to hold this to get my money back?”

From the 1970’s through the noughties, US interest rates averaged around 5%, or 5 divided by 100. This meant that if you held a term deposit account, it would take 20 years (5/100) for you to make your money back, just in income. You would also get the capital back (hopefully you would get the capital back, but as we have found out with some bank collapses, this is not 100% guaranteed).

Twenty years is an acceptable timeframe for many investors, as we can foresee that in our lifetimes, and it’s about the time you would be responsible for a child or a mortgage.

To understand why stock prices, property prices and bond prices will fluctuate (in a rational market), we see that sometimes, an investment may pay more than 5% income, making it seem more valuable than cash at the bank.

For example, a bond yielding 6% would see your money return in just 17 years, so we would expect the price of the bond to rise, as it is more desirable than (the 20-year timeframe of) bank interest. If a property was paying 7% rent, your money would return in just 14 years, so we would expect that the increased desirability would cause the price of the property to increase proportionately.

Unfortunately, humans are not always rational, and so our markets are not either. Sometimes, rumours or hype will inflate a particular asset by too much, and it may (briefly) trade at 30, 50, or even 100 or 1000-year timeframes. Such hype is often followed by massive corrections (eg. the “Tech Wreck” of 1999)

Right now, the world is dealing with COVID19 (COrona VIrus Disease 2019), a disease which emerged in 2019 and takes lives and closes businesses. We are also dealing with COVID08 (Creation Of Virtually Infinite Dollars 2008), a disease that started with Quantitative Easing (mindless money printing) measures during 2008’s GFC1, which erodes the wealth of ordinary citizens by inflation.

As the central bank prints another $9 Trillion in unbacked fiat currency, banks and government can use these funds to purchase stocks and bonds, propping up the prices. The problem is, with severely slashed earnings, the stock multiples are way out of historical alignment.

Students of history will know that when banks or governments start to print infinite dollars, hyperinflation follows and the wealth of the working class is wiped out. Germany did it in 1920’s, Zimbabwe did it in the early noughties, and eventually, a Trillion dollar note was not enough to buy a loaf of bread.

Printing infinite dollars has never fixed an economy, ever. Not ever.
In fact, the world’s first fiat currency, the Chinese Yuan dynasty’s Jiaochao suffered hyperinflation from overprinting back in the year 1260.

Whilst central banks concentrate on “big name” stocks that grab headlines (eg. the ‘FAAANG’ stocks or Tesla), it may be possible for investors to find value in smaller labels. Judging by long-term dated bonds or bank deposits, standard bank interest looks to be sub-1% for the next five to ten years. Therefore, any stocks, bonds or properties which yield 3% or over could seem attractive to investors.

If you can manage to find a legitimate asset which has a sustainable yield of 5-6%, be prepared that its price may double when others discover it.

The economy will be in *truly* good shape, when
a) asset prices drop precipitously to levels where current yields return to a more normal 20-30 year timeframe instead of 100 or 1000-years (eyes on Visa, Tesla, Facebook), or
b) earnings dramatically increase so that current prices return to 20-30 ratio rather than 100 or 1000

Most people understand enough math to know that, if you set aside 10% of your income into savings every month, just one bad month will knock out your profits for a year, and one bad year will knock you out for a decade.

We have seen that most companies have either not saved enough, or have paid out too much, and cannot sustain themselves through a bad 2020.

I feel that, after a very bad 2020, it is unlikely that corporate earnings will bounce back dramatically within the next 2-5 years, so my bet is on a fall in asset prices. It’s simple when you think about the math. Far too many people invest on emotion, and that is where they can come unstuck.

Just because I may love the look of a Tesla Roadster, or the allure of a new iPhone, does not mean I should buy their stock. Use your emotions, by all means; but check them against cold hard math. If the ratios are beyond your comfort or comprehension, then perhaps sit this one out.

As this is pressed, legendary stock investor Warren Buffett is holding around US$128 Billion in cash. We all know the earnings on this are under 1%, so perhaps the Oracle of Omaha is stocking up on cash and waiting to buy at much lower multiples than those which are currently available.  This was exactly what he did during GFC1; making over $10 Billion when markets dropped and laid their bargains bare.

For #GFC2, Buffett is sitting on more cash than he ever has in his 70+ year investing history. A patient man, Buffett is “afraid when others are greedy” and “greedy when others are afraid”. Those who wish to invest wisely could emulate the best investor; using prudence and patience in equal measure.