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Executive Summary

As year-end approaches, I decided to review where we are and compare 2020 to historical times.  The year began with weakening growth in both corporate earnings and gross domestic product followed by the onslaught of the COVID-19 pandemic and closures.  To fight the negative impacts, the Federal Government unleashed $3 trillion in stimulus funds.  During this time, the stock market plunged over 30%, only to bounce back to new highs.  Contrast this with the first graph in The Details showing the U.S. and Europe’s dropping economic activity and the second and third illustrations of market overvaluation.  Some justify high stock prices because of low interest rates; however, the next graph shows historical periods of low interest rates have not correlated with high stock prices.  Speculators appear to be betting for higher prices based on margin debt and stock option put/call ratios described below.  Many prognosticators believe a correction will be immediately followed by a quick bounce higher.  The final graph shows Japan’s market history indicating it may not happen.  The U.S. appears to be following in their financial footsteps.  History does matter.

Please proceed to The Details.

“A generation which ignores history has no past and no future.”
–Robert Heinlein

The Details

As year-end approaches, I thought it might be good to review where things are and compare to historical times. To say 2020 has been an unusual year would be putting it mildly. The year began with weakening growth in both corporate earnings and gross domestic product. Then came COVID-19 and forced business lockdowns resulting in massive business failures and surging unemployment. To attempt to stem the tide, the Federal government with assistance from the Federal Reserve Bank (Fed) jumped in to provide almost $3 trillion in stimulus funds. This was over triple the largest stimulus package enacted during the Great Recession (proclaimed the worst recession since the Great Depression). Economic growth bounced with this government provided boost, but again began to slow as the stimulus funds ran dry and COVID-19 reaccelerated. During this time the stock market plunged over 30%, only to bounce back to new highs thanks to the Fed and Federal government, all while fundamentals fell apart. So, let’s examine some of the details. I will show a number of pictures (graphs) in order to provide historical perspective.

I recently attended (via Zoom) a continuing education seminar sponsored by the international CPA firm BDO. The following statistics were discussed during the event: Since March 1, 2020, 213 corporate bankruptcies have been filed. One in six restaurants, or about 100,000, have permanently closed. Eight thousand retail locations have shut down. About 400,000 airline employees were either terminated, furloughed or told they may lose their jobs. And over 11 million Americans are officially unemployed (over 20 million are receiving some form of unemployment benefit).

Renewed weakness in economic activity both in the U.S. and in Europe can be seen in the graph below.

As a result, real economic growth for the full year 2020 will likely fall about 2.8% compared to 2019.  Net earnings for S&P 500 corporations are estimated to plunge around 33% in 2020 versus the prior year.  Corporate earnings at the end of 2021 are estimated to only be around 3% (or less) higher than 2019 earnings.  Yet, the S&P 500 is currently up about 14% for the year.  This clearly illustrates how the stock market has become a place for speculators hoping the Fed can print enough money to keep the market afloat.  To see how far out-of-line the S&P 500 has become, the following chart from Crescat Capital outlines 15 different valuation methods.  And every one shows the market being valued in the highest decile ever.

And the following graph shows how the total price of all non-financial stocks (market cap) to GDP is higher than ever before.

Some speculators attempt to justify high prices by pointing to low interest rates.  If prices should represent the present value of a long-term stream of cash flows, and one uses an extremely low discount rate (to represent low interest rates), it provides a higher present value, BUT (and that is a big BUT) it follows that future growth would also be low, reflecting the low discount rate.  The graph below illustrates other times in history when low rates did not correlate with high stock prices.

When speculators enter drastically overvalued markets, oftentimes they turn to derivatives to boost performance.  The use of derivatives in large doses tends to make overvalued assets more fragile.  And, when the correction eventually comes, they can accelerate the downturn.  The current bubble has been boosted by purchasers of “call options” which give the owner the option to purchase the security at a specified price (strike price) over some time period.  If the security rises in price, the option holder can purchase it at the lower strike price.  Put options are used when betting on falling prices.  The graph below highlights the record volume of call option buyers hoping for continued increases in prices.

And the following graph shows the Put/Call Ratio, or the level of put options purchased divided by call options.  When call options greatly outnumber put options, the ratio falls indicating more speculators are buying call options expecting markets to keep rising.  On the flip side, fewer are purchasing put options to hedge against a downturn.  When everyone appears to be on the same side of a transaction, the risk that something else will happen rises.  In fact, one of legendary investor Bob Farrell’s 10 Market Rules to Remember, #9 states, “When all the experts and forecasts agree — something else is going to happen.”

Many investors have come to believe that after a market correction, the stock market will always bounce back.  The graph below shows the experience of Japan’s Nikkei 225 Index.  The Index peaked in 1989 and has yet to recover to that level.  Some might say, We aren’t Japan.  True, but if you look at the accumulation of our debt and actions by the Fed, it appears we are following in their footsteps with a couple decade delay.

Any way you slice it, the stock market is more stretched and in a more precarious environment than ever before in history.  How long the Fed can prop up the speculative market depends upon how long stockholders keep the faith.  Once something rattles speculators, with the amount of debt-financed stock purchases and derivative activity, the unwinding could occur quickly.  And if Japan is any example, the ramp back might not be so quick next time.  History matters.

The S&P 500 Index closed at 3,709, up 1.3% for the week.  The yield on the 10-year Treasury Note rose to 0.95%.  Oil prices increased to $49 per barrel, and the national average price of gasoline according to AAA rose to $2.22 per gallon.


© 2020. This material was prepared by Bob Cremerius, CPA/PFS, of Prudent Financial, and does not necessarily represent the views of other presenting parties, nor their affiliates. This information should not be construed as investment, tax or legal advice. Past performance is not indicative of future performance. An index is unmanaged and one cannot invest directly in an index. Actual results, performance or achievements may differ materially from those expressed or implied. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy.

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