Hopium: The Miracle Drug That Makes Everything Seem Okay
The decade of the 2010s was among the best for making money in stocks and bonds, but this current decade has not started so well due to COVID-19, or more appropriately the Wuhan Virus. All focus is currently on the Fed making everything better and returning to normal. The stock market is recovering based on this “Hopium.” But Hopium is Hokium that makes us forget all the other threats we discussed previously in January 2020. These threats have not gone away and have actually become more threatening. Here’s an update on our previous warnings of 10 reasons to reduce risk now.
Stocks and bonds are expensive
There are a couple ways to measure how expensive stocks are: Price/earnings ratio (P/E) and Stock Market Value as a percent of Gross Domestic Product (GDP). Current P/Es of 30 in February are twice the historical average of 15. Investors were paying twice as much for each dollar of earnings as they have paid on average in the past. As shown in the following table, if P/Es return to their average, prices will fall 46%. If they remain at their current level prices will increase 8% due to 2% dividends combined with 6% earnings growth. There are reasons to believe that P/Es will decrease, as discussed in the following sections of this article. The current pandemic has resulted in some price decreases but decreases in earnings have caused P/Es to remain near 30. Stocks remain expensive.
Warren Buffett measures expensiveness as the ratio of the value of the US stock market to total GDP. This “Buffett Indicator” is currently 140%, the second highest on record, exceeded only in 2000 when it stood at 160%. Losses in a market that is substantially larger than economic output have a big wealth effect, leading to recession, defined as a decrease in economic activity. Like P/E ratios, both the numerator and the denominator of his ratio have declined but it’s not over yet. The ultimate outcome of COVID-19 remains to be seen.
Similarly, bonds remain expensive, as evidenced by yields that are near zero. Bond prices increase when bond yields decrease. Presumably zero is the limit on how low bond yields can go, although some foreign bonds are “paying” negative interest; these are extraordinarily unusual times. Bond yields are being manipulated by the Fed as part of its mission to rescue the economy with monetary stimulus.
As explained in this article, per capita world debt has soared above $200,000, and the US is in the top 3 most broke nations. Central bank solution to the current crisis has been to throw money at it, with the US leading the way with an additional $5trillion on top of the $4 trillion in Quantitative Easing. Most observers now see serious inflation ahead. The debt crisis has created the following issues:
- Inverted yield curve
- Bond defaults
- Rising gold prices
- Trade wars
- Negative interest rates
- Threats of inflation due to currency devaluation
- Geopolitical threats
The US is in confrontations around the world with Iran, Iraq, North Korea, Afghanistan , China and others. Some are economic, like the China trade wars, while others are political/religious. One of the many fears that emerge from these conflicts is the possibility of nuclear attack, say in the form of a dirty bomb. Aside from the physical and emotional toll, stock and bond prices would plummet as a result of fear of even more destruction, and how the US will retaliate.
COVID-19 increases the tension with China and triggers concerns that this pandemic might be a cruel strategy in the battle to be the dominant economic power.
Federal Reserve delicate balance
The Fed engineered a recovery from a serious crisis in 2008. It’s fighting fire with kerosene, and it’s worked so far, but it is dangerous. Some day the Fed will need to unravel quantitative easing (QE) and release $4 trillion from bank reserves. No one knows what will happen when the Fed removes the low interest punchbowl, and tries to sell $4 trillion in mortgage obligations, but it could get ugly. When Warren Buffett was asked what he thought about the ultimate outcome, he said it is the biggest gamble the Fed has ever made, and no one knows how it will end, not even the Fed.
Adding another $5 trillion to the debt side of the balance, more than doubling it, seriously compounds the problem.
Major countries can currently just barely afford to pay the interest on their debt. If interest rates increase they will no longer be able to pay.
If inflation increases, bond yields will rise, pushing down bond prices. Also, stock prices will decrease because future earnings will be discounted at a higher rate. Growth stocks will suffer most.
Increases in inflation will happen if the world “monetizes” its debt, devaluing its currencies to pay creditors. It will also increase with the injection of $trillions in COVID relief
New problems will arise that we just don’t know about today
UBS and other financial firms warn of dangers that are brewing like water shortages in parts of the world. We don’t know what we don’t know. COVID-19 is an example of something we didn’t know when I originally wrote this article.
The 2020 election
If the new president doesn’t deal effectively with these threats, their consequences could be exacerbated. History shows that the Republican party is more pro-business, which could help companies, and the economy, struggle through a recession. President Trump’s run for re-election will hinge upon the state of the economy in November 2020. The pandemic has not done the president any favors, although he will be judged on his handling of this health disaster
Economic cycles are at or near peak
According to Crestmont Research, an economic think tank:
The year 2019 and the decade ending 2019 delivered another pair of records for the history books: (1) as of July 2019, the current economic expansion became history's longest and, (2) 2010-2019 is the first calendar decade without a recession (Recessions by Decade).
As long as good economic conditions prevail, significant downside risk in the stock market is likely to be deferred, and the market will likely benefit from its current momentum.
Nonetheless, stock market valuation remains high (Secular Stock Market P/E), and volatility has returned to the moderate zone (Stock Market Volatility: An Erratic Cycle). For more on volatility, see Volatility in Perspective.
Lastly, consistent with recent years, 2019's initially hopeful surge in reported earnings tapered throughout the year (Earnings Trends: History & Future). It's unclear whether the final reports of 4Q19 EPS will reflect the sixth "big dip" in a row. Each of the past five years had significant declines in reported EPS as the year was finalized after year-end. Update pending...
Recessions happen. They are an economic fact of life that can be a game changer in an election year.Investor sentiment was very low as we entered 2020
According to Capital Market Consultants, Inc, the US economic outlook at the end of 2019 is precarious:
- The Economy is rated Weak
- Market valuation is rated Very Expensive
- Investor sentiment is rated Extremely Bearish
- Social Security and Medicare are running out of money
Social Security and Medicare have started down the path of destruction. 2018 was the first year when tax receipts didn’t pay for Social Security and Medicare benefits. We are spending down the corpus and will have spent all of the Social Security Trust by 2034, while Medicare monies will only last until 2026. This might sound like we have time, but we don’t, especially since nothing is being done to head off these catastrophes. It’s full speed ahead into the reckoning. Raising taxes just became less of an option in the throws of COVID-19.
The reported US national debt of $34 trillion is currently 120% of GDP, a level only seen before in the wake of World War II. But unlike the last time, there are no signs that debt has peaked. We use a percentage of GDP to convey our ability to pay. If every dollar of output our country generates this year were used to pay our debt it would not be enough. Of course, we’re not obligated to pay right away and therein lies our apathetic attitude; we trust some miracle will solve the problem someday. In fact, there are serious conversations about increasing promises, like socialized medicine.
But that’s not the whole story. We’ve made promises to older people that simply can’t be kept unless the promises are changed (broken) and we burden today’s young people with much higher taxes; the fixes are not pretty. As shown in the last row of the following table, the present value of the promise to pay Social Security benefits is $29 trillion more than projected receipts, and adding Medicare’s $47 trillion promise brings our off-the-books liability to $76 trillion, more than twice the published $34 trillion liability. Our all-in national debt is an astronomical 390% of GDP
What you should know about Social Security and Medicare
Source: Compiled by GlidePath Wealth Management from reputable sources
Something has to give, but it appears that our policymakers will do nothing until it blows up and then they will blame past administrations. Adding to this problem, defined benefit pension funds are severely underfunded, which means they don’t have enough money to pay beneficiaries.