Greetings all, and happy Canada Day to all my Canadian friends, and an early happy Independence Day to my U.S. friends and family. Now that I have covered some background, let’s walk through the important developments in the past 1-2 weeks in regards to financial markets and the economy, which all tie in to our march further into the Fourth Turning
Financial Markets
What a roller coaster in the financial markets since late February. As the COVID-19 scare built, the financial markets took a big hit. Then, an incredible rebound occurred, starting in late March, pushing stocks back up close to, or in some cases, exceeding the all-time highs from February. Was this the shortest bear market in history? Not so fast. Beware of the potential for a classic “bull trap.”
The driver of the current stock market rebound has clearly been central bank policy and massive increased liquidity, led by our wonderful Federal Reserve Bank in the U.S. Before the COVID crisis hit, by almost any measure markets were overvalued. COVID was the pin prick that started the deflation of a financial asset bubble. However, central banks took quick action (much quicker and more aggressively than 2008), in effect re-inflating the market bubble. Their actions were quite breathtaking. It is no doubt that this has been the primary catalyst of the market rebound.
However, there is another phenomenon that is occurring that is pushing the U.S. stock market higher. Apparently driven by being stuck at home, bored, and nothing else to do, along with government stimulus checks and unemployment benefits (in fact, higher than some U.S. citizens take-home pay) providing some immediate cash with limited places to spend it, a new army of day traders have materialized, who have decided to “play” day trader to compensate for the lack of sports betting opportunities, led by DDTG (Davey Day Trader Global – https://twitter.com/stoolpresidente). In my opinion, this is classic market euphoria that has happened historically as markets are driven by extreme euphoria and FOMO (fear of missing out).
I read a lot in my spare time, and I recently finished a really good book, Lords of Finance by Liaquat Ahamed, that follows the story of the key central bankers who were the key financial leaders from World War I until the great depression hit. Our current day trading phenomenon reminded me of the market euphoria in the months leading up to the Great Depression. Back then, stock market investors were almost exclusively wealthy individuals. However, that changed in early 1929 as market euphoria took hold. The situation today seems very similar. And this time we have the Robinhood investing app and Davey Day Trader Global (DDTG) instead of the (quite tame in comparison) musings of Irving Fisher.
If you are not an intense sports fan, you may not know who DDTG (Dave Portnoy) is. He started a website that focuses on sports, betting, and other “bro” topics. And right before the pandemic hit, he sold 36% of his business, Barstool Sports, to Penn National, a casino company, for $163 million. Talk about great timing! And with no sports to talk about or gamble on, Mr. Portnoy decided to play the market with a portion of his windfall. In another stroke of luck, he started buying stocks right around the time that the market bottomed in March. With his mantra of “stocks only go up,” and being right SO FAR, he has proceeded to call out investing icons such as Warren Buffett (he’s “washed up…I’m a better stock picker than he is now”), Howard Marks and others. Of course, this is all to entertain his fans when there are no sports to discuss, but it does remind me of stories that were documented in the lead-up to the crash of 1929.
And many of DDTG’s followers are new investors, also sitting at home with no sports to bet on, that have signed up to use Robinhood to invest. Robinhood is a new online stock app where you can invest in the markets with no fee for buying or selling. It is the new hot app for the young crowd that have started investing for the first time. If you are one of these new investors, no offense, but you may want to study some Financial Markets 101 before you start investing your money. As proof of the absurdity of the markets, let’s revisit the Hertz bankruptcy that I covered a few weeks ago. As a reminder, Hertz filed bankruptcy on May 22. Let’s now look at the chart below from www.robintrack.net, a website that tracks Robinhood investor activity.
The green line is the number of Robinhood accounts that own Hertz stock, and the pink line is the share price. If you look at the far right of the graph, you will see activity leading up to and folllowing Hertz’s bankruptcy as our novice investors poured into the stock.
| Date | # Robinhood Investors | Stock Price |
| February 20, 2020 | 1,064 | $20.29 |
| May 22, 2020 | 44,297 | $2.84 |
| May 25, 2020 | 44,354 | $0.65 |
| June 5, 2020 | 94,993 | $5.53 |
| June 15, 2020 | 170,814 | $2.83 |
As you can see, post-bankruptcy our new market participants drove the share price up from $0.65 at the time of bankruptcy to $5.53 almost two weeks later! That’s a 751% increase in the stock price! For a bankrupt company!!!! For new market participants, here is some advice: you may not want to invest your money in stocks where the company has filed bankruptcy. Why? When a company files bankruptcy, they have typically run out of cash and cannot get any further financing. Their liabilities are greater than their assets. The credit risk is so high, no one will lend to them. They may be able to restructure, sell assets, and continue to survive.
However, shareholders almost always get NOTHING! Zero. Nada. Zilch. They are the last in line to get anything of value in a bankruptcy. The holders of debt and other liabilities will get some compensation (usually much lower than what is owed), but not shareholders. If the company survives, it will typically issue new shares to new shareholders (in many cases a form of compensation to lenders), but existing shareholders prior to bankruptcy will never recover any of their investment. So our new breed of day traders must have assumed that since Hertz is a company with a very long history, it must be a great investment to get in at less than a dollar! Oops.
So the signs of market euphoria are everywhere. I am reading that the “smart money,” or professional investors, are sitting on the sidelines during this market rally. Why? Because the disconnect between the market and the underlying economy are at extreme levels, and as mentioned before, at historically high valuations. There is some small chance the market can stay elevated at these levels, driven by the massive liquidity provided by the Fed, but I believe it is much more likely that another drop will come soon, regardless of central bank actions that drive up markets.
One of my favorite reads is the bi-weekly newsletter Things that make you go hmmm by Grant Williams. In his most recent edition (June 21), titled Inconceivable, he covers some of the crazy things going on in the markets right now including Robinhood and DDTG.
Lord knows, in recent years, I’ve found myself uttering [Inconceivable!] on countless occasions but, since the beginning of this month, events have taken a turn for the preposterous…
Things that make you go hmmm, June 21, 2020
That was his introduction, and afterwards he covered the Hertz situation in detail as well as other similar situations. In reference to the new group of day traders, he comments as follows:
These people aren’t here for a long time, they’re here for a good time (although, lately, they’ve been having such a good time that, who knows? Maybe they’ll stick around a bit longer).
Things that make you go hmmm, June 21, 2020
We have certainly seen a bit of a pullback in the last week, which by no coincidence occurred at the same time as the Fed’s balance sheet started to contract a bit. I fully expect a lot of volatility for some period of time, with wild swings up and down. Trade carefully!
The Economy
The recession that we are now in is unlike previous recessions. Usually, recessions are triggered by an event in the financial markets, such as the dot com bubble in 2000 or the mortgage market collapse in 2007-2008, which then affects the economy. This time, it was the economy experiencing an extreme shock because of the virus hitting, causing businesses to shut down, resulting in a demand shock. This was after experiencing a supply shock when China, the world’s factory, shut down. It has created a chaotic situation for many businesses. The unemployment numbers are shocking, like nothing before with the speed in which it happened.
I read two different articles discussing this in the past few days (both are free newsletters). The first is Thoughts from the Frontline by John Mauldin, whose June 26 newsletter was titled “A Recession Like No Other.” Here are a few key points I gleaned from his analysis of the “Corona Recession,” with reference to recent published remarks from economist Woody Brock.
I thought we were headed for a credit crisis, centered on corporate debt rather than mortgages, as happened in 2008. The Fed’s decades-long easy money policies have many businesses leveraged to the hilt. That remains the case and could still become a bigger problem but for now, we are in something unique: a supply-and-demand-driven recession. Specifically, service supply dried up almost overnight as people lost those service jobs and, as will see, those with more money started to save dramatically more, further reducing demand.
Normally, some kind of trigger or “shock” makes business activity contract. Tighter credit or higher interest rates are often the culprit, not simply falling sales. Unable to finance continued operations, businesses close and lay off workers, who then reduce their consumption. The effects cascade through the economy and recession begins.
This time, the shock came with the coronavirus and our reaction to it. Note, it wasn’t just government-ordered shutdowns. Data now shows consumer spending started failing weeks before governors acted. Retail service businesses saw store traffic falling and, with risks to employees and customers rising, many closed even when not required to. But the result was the same: Business activity contracted and triggered a recession.
John Mauldin, Thoughts From the Frontline, June 26
I then read Bill Blain’s The Morning Porridge June 29 edition, titled “What if it’s just begun?”
This crisis is unlike anything I’ve experienced before. Normally a market crash is [an] explosive event – it occurs when something in the financial sphere breaks; like confidence in housing and financial systems in 2007, or valuations in the Dot.Com crash, or faith in credit constructs like during the European Sovereign Debt crisis in the 2010s. In each case of financial mayhem I’ve experienced since the Great Perp Crash of 1986, the initial shock and horror gradually lessens as the market discounts the shock, shrugs it off, and carries on…
This time it feels different. The crisis started off with a meteor strike – the virus. We’ve never seen anything impact the real economy so dramatically. Normally – it happens the other way around: financial crashes impact the markets and only then does the pain trickle down into the real world. This time it’s real jobs and production that got hit first. That’s fundamentally different.
I’m not convinced that markets really understand that difference. The effect on the real economy of financial failure is felt in terms of the flow of capital to businesses. If a bank blows up – it will impact savers and borrowers. This time we’re looking at how will crashing earnings and diminished rental incomes hit the financial markets – but they are behaving as if it’s just another round of QE [quantitative easing] Infinity for the markets to arbitrage. As we all know markets are completely delinked to the real world at present.
Yet, the damage the real world is going to inflict on financial markets is going to be huge – but that’s not what I see the banking regulators and authorities preparing for. They’re pushing financial institutions to participate by easing lending and supporting confidence. You can understand why – yet they also know a crisis [is] coming. Just read the dissenting statement by Fed Governor Lael Brainard after she stepped back from the Fed’s decision to allow bank dividends: “many large banks are likely to need greater loss absorbing capital to avoid breaching their buffers in adverse circumstances nest year.”
The bottom line is global central banks know a financial crisis is possible/probable.
Bill Blain, The Morning Porridge, June 29
So this time is really different, and not in a good way. Our central bankers, already incompetent in so many things, appear to be “flying blind” in our current situation. I fear we are beginning to see the last few snowflakes that will eventually start an avalanche of actions that will drive negative consequences for the economy. There are so many companies that have increased debt on their balance sheets, driven by cheap money. And in too many cases, they have used this cash to buy back stocks, increasing their executive bonuses at the expense of adding financial risk to their company. I do not see this ending well.
Bankruptcies continue to pile up. Chesapeake Energy, a company that pioneered fracking to extract natural gas, was the latest headline casualty. Also added to the list are Whiting Petroleum, Cirque de Soleil, Aeromexico and Chuck E. Cheese. We have now had 17 major retailers file for bankruptcy so far this year, including GNC, Roots USA, Tuesday Morning, True Religion, Centric Brands, Modell’s Sporting Goods, J.C. Penney, Art Van Furniture, Stage Stores, Bluestream Brands, Aldo, Pier 1, Neiman Marcus, SFP Franchiees Corp., and J Crew. Here in Canada where I now live, several well-known retailers have filed, including Reitman’s, Sail, and Aldo. I am confident the list will continue to grow. Many of these companies will survive, but with fewer stores and fewer employees. And this is on top of last year’s retail bankruptcies that resulted in over 9,500 stores closing. This year will be worse.
As far as who could be next, keep an eye on Michaels, Carter’s, Tailored Brands, Game Stop, Designer Brands International, Bed Bath & Beyond, and Ascena. There are also a lot of restaurants at risk, especially those that rely on the dine-in segment. And if a large number of retailers file for bankruptcy, who gets impacted? First in line, the owners of the shopping centers where these stores are located.
So next you should keep an eye on retail Real Estate Investment Trusts (REITs), especially those with a lot of debt. If tenants are not paying rent, and leases get discharged in bankruptcy resulting in vacant units, this will inevitably lead to the owners of that real estate having financial difficulties. The avalanche starts picking up steam. Travel-related industries are also being hit hard. The CEO of Air BNB even said this week that the travel industry will never get back to “normal,” referring to pre-COVID-19 conditions.
I ran across a good article about the impact on retail and shopping centers this week. There are so many small independent retailers and restaurants that will not make it through this crisis.
In short, bricks and mortar retail has been caught in a pincer movement, flanked on one side by Covid-19 itself, and on the other site by its cure. You know this already: The virus separated us, the cure institutionalized that separation, forcing societal shutdown that has driven us into our deepest recession in perhaps living memory, a recession that seems certain to run several years. The coronavirus means we will remain wary of one another until there’s a vaccine, perhaps longer; the cure means a majority of Americans will have little to spend.
What does this portend? Putting aside kids swarming the beach towns, few of us wish to take more risks than necessary. Driving on a freeway entails infinitesimal risk, but we do it to get somewhere; going shopping now involves a minute risk, but we accept it if the shopping is essential…
Our essential retailers – supermarkets, drug stores, banks, convenience stores and gas stations – are doing fine; in fact groceries and gas are killing it. Someone’s idea of essential, liquor stores and cigarette shops, are not complaining either…
Personal services – beauty shops, nail salons, dry cleaners, massage parlors, yoga studios and gyms, etc. – win on cheap, but lose on distancing. Fortunately for some – notably, hair and nails – essential trumps distancing; these shops will come back swiftly. Others, like dry-cleaning and massage, are less essential and will take time to regain their pre-Covid levels.
Finally, there’s the sweat subcategory: small gyms, bike spinning parlors, yoga studios, etc. Absent an amazing vaccine, these tenants may be in serious trouble. You can’t make money at 50 percent maximum capacity and you’ll never convince some meaningful percentage of your customers that they’ll be safe dodging sweat in a tightly packed room.
Following the distancing/cheap lodestone, food shapes up like this: drive-throughs are golden, traditional take-out (e.g. pizza) is rocking, and those restaurants that can successfully ramp up their take-out should be fine.
By the way, the coronavirus didn’t create retail’s larger problem – excess capacity – it merely pulled its curtain back. According to Forbes, we have roughly 50 square feet of retail space per capita in the USA while Europe has just 2.5 square feet. Washington DC has a restaurant for every 103 residents, while San Francisco has one for every 201 residents. That’s a lot of competition…
Bringing this home: To date, we’ve permanently lost half-dozen retailers, from restaurants to clothing to massage. Tenants who in effect said sue me, I’m taking a hike. To compound this unpleasantness, it would be fair to say that replacement shop tenants are just behind the spotted owls on the endangered species list. But if there is a safe harbor in retail, it’s a supermarket center in a good residential neighborhood. Without plan or compass, we happened to bob into that harbor years ago.
John E. McNellis, Principal at McNellis Partners, via Wolf Street (h/t ZeroHedge)
That is a great summary by a retail shopping center owner. Enclosed malls are the clear loser so far in this crisis, with open-air power centers and neighborhood centers anchored by a food retailer being best positioned to weather the storm. As difficult as the past three months have been for the retail and travel industries, another disruption with infections ramping up in the south and west in the U.S. is a problem. I believe there will be a collapse in these industries if a significant portion of the U.S. goes into a lockdown again. It will be brutal.
Shockingly, there are still economists that are predicting a quick “V-shaped” (i.e. rebound by year end) economic recovery. Seriously, what are they smoking? UCLA Anderson and senior economist David Shulman have updated their second quarterly economic forecast, with some interesting tidbits.
…the virus pandemic has ‘morphed into a Depression-like crisis’ with no V-shaped recovery until 2023.
‘To call this crisis a recession is a misnomer. We are forecasting a 42% annual rate of decline in real GDP for the current quarter, followed by a ‘Nike swoosh’ recovery that won’t return the level of output to the prior fourth quarter of 2019 peak until early 2023′ Shulman writes in a report titled “The Post-COVID Economy.”
“Simply put, depsite the Paycheck Protection Program, too many small businesses will fail and millions of jobs in restaurants and personal service firms will disappear in the short run. We believe that even with the availability of a vaccine, it will take time for consumers to return to normal” Shulman writes.
Zero Hedge, “;Depression-Like Crisis’ Unfolding With No V-Shaped Recover Until 2020, UCLA Anderson Warns”, June 25
That is not encouraging at all.
So, who holds the debt of these companies that are filing or are at risk of filing for bankruptcy? Banks, pension funds, sovereign wealth funds, insurance companies, etc. hold most of this debt. And with unemployment continuing to grow, and the extra federal subsidies for unemployed workers set to expire in a few weeks, it is difficult to see how consumer spending will get back to the levels before the coronavirus hit.
Chris Whalen of The Institutional Risk Analyst had some interesting insights on the commercial real estate environment.
So how big is the impending commercial real estate bust in the US? Bigger than the residential mortgage bust of the 2000s and also bigger than the commercial real estate wipeout of the 1990s, including the aftermath of the Texas oil boom of the late 1970s and 1980s…
The latest Mortgage Bankers Association survey shows that commercial banks continue to hold the largest share (39 percent) of commercial/multifamily mortgages of $1.4 trillion. Agency and GSE [Government Sponsored Enterprise] portfolios and MBS [Mortgage Backed Securities] are the second largest holders of commercial/multifamily mortgages, at $744 billion (20 percent of the total). Life insurance companies hold $561 billion (15 percent), and CMBS [Commercial Mortgage Backed Securities] and other ABS [Asset-Backed Securities] issues hold $504 billion (14 percent)…
The fact of the COVID19 lockdown, the riots and looting following the killing of George Floyd by the Minneapolis police, and the coincident rise of telecommuting, which keeps people away from the large metros, raises questions about the entire economic structure of cities. So long as social distancing is required or even the preferred option, many of the institutions and structures within the big cities no longer function.
Connor Dougherty and Peter Eavis reported in the New York times on Friday: “Faced with plunging sales that have already led to tens of millions of layoffs, companies are trying to renegotiate their office and retail leases – and in some cases refusing to pay – in hopes of lowering their overhead and surviving the worst economic downturn since the Great Depression. This has given rise to fierce negotiations with building owners, who are trying to hold the line on rents for fear that rising vacancies and falling revenues could threaten their own survival…”
So how big will the commercial real estate bust be in 2020-21 and beyond? In 1991, the FDIC reports, “the proportion of commercial real estate loans that were nonperforming or foreclosed stood at 8.2 percent, and the following year net charge-offs for commercial real estate loans peaked at 2.1 percent.”
In 1991, the net charge off rate for all $1.6 trillion in bank owned real estate loans was less than 0.5%. Multifamily mortgage loans peaked in Q4 of 1991 around 1.5% of net charge offs but remained elevated until 1996.
But this time is different. Based on our informal survey of REIT valuations and individual assets, we think that the world has been turned upside down for many investors. Actual LTVs [Loan-to-value ratios] for urban commercial and luxury residential assets in many metros are well-over 100 and are likely to be restructured, albeit over a period of years. As we noted last week, it’s all about buying time.
We think that net charge offs on commercial loans could rise to 2-3x the peaks of the 1990s, with loss rates at 100% or more in some cases, and remain elevated for years to come as the workout process proceeds.
Failing some miraculous economic rebound in the major metros, look for credit costs related to commercial real estate climb for REITs, CMBS investors, the GSEs, and banks in that order of severity. Figure a 10% loss spread across $5 trillion of AUM [Assets Under Management] over five years?
Chris Whalen, The Institutional Risk Analyst, H/T ZeroHedge, June 8
If I can summarize, a “V-shaped” recovery is pipe dream. The dominoes are already starting to fall. Many of the job losses to date will likely move from temporary to permanent. Our economy is no longer driven by manufacturing, as it today is primarily a service economy. And when many service industries, such as retail, restaurants, and travel, have suffered the brunt of COVID-19, a significant portion of our economy is suffering.
Conclusion
I originally planned to also cover some geopolitical events in this post, but my ramblings on the financial markets and the economy were quite a bit longer than I anticipated. So I will cover some geopolitical events from the past few weeks in my next posting (hopefully this weekend).
Our economy has taken a gut-punch, and we are staggering. Unfortunately, I do not believe the Fed’s actions are the cure for what ails us. As I covered above, this shock to our economy and financial markets is unique. And our ability to recover from this is negatively impacted by the central bank’s actions over the past 20-30 years to “kick the can down the road.” At some point, we will reach the end of the road, with nowhere to go other than off the cliff that is dead-ahead.
We find ourselves in the midst of our Fourth Turning crisis, with no easy way out. The next few years will be hard, very hard. But I still believe in American Exceptionalism. We will come out of this stronger than before. We have no choice but to “hunker down’ and face the challenges full-steam ahead. But the silent majority in our country must stop the silence, and be heard. Otherwise, we will lose all those attributes that have made us exceptional. And we need true leadership! I have yet to see any real leaders in our government step up to give me confidence that we have leadership in our country that can maneuver us through this crisis. We are not a country of chaos and disunity. Although if you viewed the current events of the past few months, it doesn’t seem to be the case.
I have spent the majority of my career in the real estate industry, and I find myself in the middle of the current economic storm. I am just very thankful that I am employed by a company that has taken a conservative financial approach to managing their business, with a strong balance sheet that can survive when others become insolvent. I am also very thankful that I have a job where I can effectively work remotely from home. I know many others who do not have that option.
Let’s prepare ourselves for the challenges ahead. I hate to say it, but I doubt we will ever go back to the good times we had just a few short months ago. I have heard many speak of the “new normal,” and I think that is absolutely correct. Change is hard. And we all now face a multitude of changes in our life. Economic. Social. Geopolitical. One of my favorite quotes, from a Kellly Clarkson song, is, “What doesn’t kill you makes you stronger.” Let’s all persevere, and come out stronger on the other side of this Fourth Turning. If you have no idea what I am talking about when I reference the Fourth Turning, go check out my post on the subject. Check out The Fourth Turning website (https://www.fourthturning.com/). And read the book. I know some of you have already done that.
Happy Canada Day and Independence Day (and Happy Summer to all others),
Brent
Seay Economics 