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Melt Down

Yesterday, the U.S. stock market suffered its biggest one-day fall since the Black Monday crash of October 1987 and European equities had their worst day ever with the German Dax falling -12 %, Spanish equities -14 % for Spain and Italy breaking all records with a fall of -16 % in one single day.

The records do not stop there.

Over the past five days, US equities lost 18 % of their value while European stocks lost 25 % on average, the sharpest fall in history.

Since February 19, 2020, almost a month ago, every stock market, apart from China and Hong Kong entered Bear market territory, officially ending the secular bull market that started in March 2009

If this is not a melt-down in equities, what is ?

The worst in history in terms of how quickly we went there…

And 12 years of stock market performances wasted for passive management

On Oct. 31, 2007, the world markets peaked before beginning the long descent that would turn into panic after the Lehman bankruptcy the following year. Today, the FTSE’s all-world index is back to where it was on that date in 2007.

As far as the stock market is concerned, the world’s largest publicly quoted companies are worth no more now than they were 12 years ago.

As for the European markets, the FTSE-Eurofirst 300 index is back to a level it first hit exactly 22 years ago, on March 12, 1998 and Japanese stocks are still far from their peak on New Year’s Eve of 1989

Interestingly enough, the only safe haven in this turmoil has been China. Over the past month, the main index is down only -1.63 %

In today’s world, when China sneezes, the rest of the world catches the virus ….

A brief history of how we got there

As our readers know, we initially called the top of the 2009 secular bull market on the 24th of January 2018 as all indexes marked a significant-top.

At the time, the FED was normalizing monetary policy, rising interest rates, offloading bonds, inflation was coming back, bond yields were rising, valuations were exceptionally high and liquidity was being withdrawn.

We also called the END OF TECH as the valuations reached by the leaders of the secular bull market – the FAANGS and Microsoft – were reaching valuations in total disconnect with the realities of their – nevertheless excellent – businesses.

In February 2018, Donald Trump launched his Trade War on the world and China, in particular, canceling trade agreements, imposing tariffs on imported goods and singling out individual companies on National Security grounds.

By questioning the logic of globalized supply chains and free trade, Donald Trump inflicted a major deflationary shock to the world economy, sending investments, manufacturing, and exports into a tailspin.

Equity markets became highly volatile, ending 2018 in sharply negative territory and the FED went to the rescue, obliging Donald Trump, reversing the course of monetary policy and cutting interest rates three times in 2019.

By then, every inflation gauge apart from the PCE Deflator considered by the professionals of the FED to be the most relevant were already way above 2 %.

In an already red hot US economy – unemployment at a 50 year low – where a massive countercyclical tax cut had already created massive liquidity, NEGATIVE REAL RATES and low nominal rates incited corporations to issue more debt and buy back their own shares at elevated valuations.

2019 was the year of the “bubble of everything”, and without solving the problem of globalization or even triggering more economic growth, adventurous hyper stimulative monetary policy lifted all asset prices.

2019 was one of the best years on record for equities, bonds, precious metals and real estate all at once and we warned investors repeatedly about the dangers of the toxic cocktail created by massive indebtedness, ultra-low interest rates, and extreme valuations.

On October 19th, 2020, yielding to the pressure of a US President obsessed by the stock market and his re-election, the FED lowered interest rates once again while already injecting hundreds of billions of liquidity in the repo market to calm a brewing liquidity crisis.

The net result was immediate, equity markets embarked on a powerful vertical acceleration as investors started chasing stocks indiscriminately by Fear Of Missing Out and lack of alternative investments, creating a true melt-up in the mega-caps stocks like Microsoft and Apple Inc.

In mid-December 2019, a mysterious coronavirus appeared in Wuhan, China apparently in an open-air food market with strange characteristics, the main two being that it is highly contagious even when patients have not yet developed any symptoms – and that it suddenly and randomly morphs into a very active and destructive pathogen of the respiratory system even in patients that are in good health – See our NORTH KOREAN FLU ? article for a deeper analysis.

It took until February 19, 2020 and an explosion of cases in Italy for the Western equity markets to suddenly measure the potentially deflationary impact of the virus on the world economies.

Since then, equity markets have gone into a true meltdown, while US Bonds have recorded the lowest yields on record ever.

What now ?

Over the past six months, we have consistently warned investors of a major equity bear market looming on the horizon and a recession to be inevitable in the USA.

We have highlighted the extremes of valuation, of leverage, of corporate debt accumulation, of excessive monetary stimulus, the return of inflation and the unsustainable parabolic moves in the US tech mega-caps.

Our question mark at the turn of the year in OUR SEVEN INVESTMENT CALLS FOR 2020 was not about the probability of a bear market, but about two possible scenarios in terms of the timing of the bear market.

. The ‘now” scenario was that the whole move since October 2019 was a massive bull trap and a turning point could happen at any time without warning, caused by a completely exogenous factor as was the case in 2000 and in 2008,

. The “Later” scenario was that we would have a correction in March before another leg up as liquidity engineered a global melt-up that would carry valuations to even more unsustainable levels.

In February 2020, we published two articles; one titled THE BIG MELT-UP describing the potential melt-up scenario, and the second titled LOOMING CORRECTION AND TECH CRASH warning investors about the events that have just unfolded.

What is clear today is that ALL the major indexes – save for China – have now entered BEAR market territory.

Technically, the 2009 bull market is over and the history of bear markets is that they tend to last for at least two years and cause major damages to equity and credit markets.

Economic Recession

Whatever the source or the origin of this mysterious Covid-19, it amounts to a second DEFLATIONARY SHOCK just as the world economy was starting to recover from the deflationary shock of the 2018/2019 Trade War.

No one describes the economic impact of the coronavirus better than Societe Generale’s economist Albert EDWARDS, who I have known and followed for three decades :

The toxic fallout from the coronavirus pandemic’s bursting of the Fed’s “everything bubble” has collided with the grotesquely over-leveraged and vulnerable US corporate sector – this puts equity markets in an even more vulnerable position. 

I’ve read enough about the coronavirus to have been persuaded that there are a variety of compelling and obvious reasons (which I won’t catalog here) to suppose the US will suffer much worse from the virus than other western industrial countries.

And clearly with an anomalously low testing rate, the US will as a consequence suffer a high headline death rate, although the ‘true’ death rate will be no worse than elsewhere. The big death rate headlines will likely hit consumer confidence very hard indeed and deepen an already likely deep recession and equity market collapse, potentially causing a significant backlash against the current US Administration. These are dangerous times indeed.

The levels of optimism and technical positioning in the equity market a few weeks back were so extreme that even equity bulls were seeing the likelihood of a steep 10-20% pullback. And that was before the realization that the coronavirus would turn into a pandemic and impact economic activity so badly.

Let me make one thing clear: I do not believe government bonds are expensive or that equities are cheap.

And if one more person tells me the equity risk premium is very high and equities are priced for recession, I will scream. This is a variant of the failed Fed Model which strategists should have given up long ago.

In the Ice Age, with the threat of outright deflation, both bond yields and PEs will be rock-bottom low. 

US bond yields have recently made strides in attaining our long-held forecast that they will converge with Japan, just as Germany did in 2014 .

Minus 1% remains our US 10 y target with a PE of around 8x, a multiple based on substantially lower recessionary forward earnings.

Investors and US investors, in particular, should read and re-read these words very carefully. They predict US bond yields at – 1% and a US Stock market trading at 8x deflated earnings.

On Friday, Donald Trump finally took the measure of the pandemic, banned all flights from Europe, declared the state of emergency and agreed to an exceptional package to fight the virus.

At the same time, a new speedy Covid-19 test has been released and authorized and systematic testing will now take place worldwide, probably showing much larger numbers of contaminated people and a death rate that will fall back towards the Italian death rate of 3 %.

Containment measures will be massive as Italy had started to do and Spain announced on Friday with the isolation of Cataluna.

Besides Trudeau of Canada and Bolsanaro of Brazil, Iranian leaders are heavily contaminated and the Vice president of Spain is contaminated too.

The G-7 leaders have agreed to act in a concerted manner but what is going to be clearly in the horizon is a global shut down of most of the countries of the world within the next two to three weeks, something that has never happened ever in modern history

These may appear to be drastic projections to those who believe that the Coronavirus will soon disappear with warmer temperatures but we are just starting to see its impact in Europe and finally in the US.

As of today, there are 133,772 confirmed cases globally and 4,969 deaths. The epidemic seems to be under control in China but is spreading massively in Europe and probably in the USA where under-testing is putting the whole population at risk.

The proportion of people infected and dying is now much HIGHER in Italy and Spain than it has ever been in China. Until now. France and America were making the dangerous bet not to test people, but the ultimate result will be much worse.

But all this still does not take into consideration the real economic impact of the shutdown and the frailty of an over-leveraged US corporate world and an over-leveraged US consumer with absolutely no medical safety net.

With 30 % of its population living on the threshold of poverty and close to 40 % of its population without adequate health coverage, America stands to be much more affected than any of the European, Japanese or Asian economies.

US corporations are running on tight cash-flows and extreme levels of debt. Shutting down corporations for two to three weeks at a time could have cascading effects with massive layoffs and a significant impact on the banking system.

With a highly leveraged consumer and an economy that is extremely reliant on consumption, a 25 % fall in the US equity market is already a massive “negative wealth effect” that will see consumers retrench as they see their 410-K lose 25 % of its value and they start fearing unemployment.

The recession may be deep and with a significant impact on real estate prices as well, just feeding, even more, the downturn.

In America, when the cycle turns negative, the cascading effects are dramatic due to the extreme leverage of the society

The “Chinese” or “North Korean” Covid-19 could well be the straw that will finally break the back of the American free-wheeling capitalist system and the world dominance of America.

Earnings recession

When it comes to corporate earnings, strategists are all busy re-working their earnings estimates down for the year

Within 24 hours, Credit Suisse Group AG, Citigroup Inc., and Goldman Sachs Group Inc. made big cuts to their projections. As this chart from Citi’s chief global equity strategist Rob Buckland shows, the necessary adjustments are huge:

Strategists have now moved from a +10 % projected increase in 2020 to a – 10 % contraction for the USA. And that is coming on the heels of a 2019 year where earnings were flat at best.

Taking into consideration current earnings of US$ 151.7 for the SP500, a 10 % decline will take them to 136.53, which at 8 earnings brings an SP 500 level of 1092 if Albert Edwards is right.

That is a 67 % decline from the Feb, 21 secular top and a 57 % decline from the 2’541 level at the time of writing.

Citi reckons that the downgrade for emerging markets, originally expected to log better earnings growth, will be even worse, taking them down to a 16% decline.

There is a silver lining though and that is China’s economy that seems to be kicking off again as the Chinese Government finally unleashes stimulative policies.

What does it all mean for Equity Markets

Bear markets have very recognizable patterns as they are by essence a psychological phenomenon of re-adjustment of expectations. Because they are a re-adjustment of expectations – and valuation – bear markets are much shorter than bull markets, 1.5 to 2.5 years on average against 7 to 11 years for bull markets.

It has to be said here that this is the LONGEST and most OVERVALUED bull market ever recorded in history and the speed and magnitude of the fall in the past month has no equivalent in history.

They usually move from extremes of overvaluation to extremes of undervaluation in three waves of sellers that come into play.

First, the “smart” investors are the sellers and their selling is continuous as any rebound – such as the one of Friday night is met by people wanting to reduce their losses. We are very much in that phase for now…

Second, institutional investors take the measure of the “Bear” characteristics of the fall and they start offloading stocks for the long term. This has not started yet.

Third, the “Dumb” retail investors who have kept hope that their portfolio would rise finally give up and sell a the bottom of the market when everybody has lost hope and is convinced that things cannot get better.

Bear markets also unfold through a typical A-B-C pattern, with two big waves down and a bear market rally in between.

The phase usually corresponds to Fibonacci retracements that have been statistically relatively correct in the history of the stock markets.

The first A phase usually stops at either 38%, 50 % or 61.8 %retracement from the entire bull market phase, the B bear market rally rebounds to either 23 % or 50 % and the final C phase can take the index to either 76 or even 100 % retracement.

To get a sense of the target levels of these various phases, we have plotted a number of charts of the main indexes

US – Dow Jones Industrial Index

If history is right, the first leg A may not be over yet and the index will have to fall to either 20’690 or to 17’975 before phase B takes hold for a rebound towards 24’000 or simply 20 690 before the last C leg unfolds and takes the index down to 17’970 in the best case, 15’200 in the “normal case” or closer to 5’000 in the most extreme deflationary case that Albert Edwards anticipates.

In 2008, the Dow Jones lost 55 % of its value before bottoming. If the same proportion were to be achieved this time around the index would bottom at 15 260.20

US – SP500 Index

US – Nasdaq

Europe – BE 500 Index

A valid question is whether the current episode is just a “crash” as was the October 1987 episode or a true bear market.

Many commentators still hope that the economic effects of the Covid-19 are temporary and will disappear as soon as the virus vanishes with the spring’s warmer temperatures.

We are not of that view as the level of extremes reached in valuation, liquidity, leverage and interest rates cal, fr a much larger adjustment – economic and financial – than a simple equity market correction.

Monetary policies have lost all effectiveness and fiscal policies will be difficult to implement in already highly indebted economies.

Moreover, the Covid-19 is the secon=d blow to the logic of globalized supply chains and globalized markets that has been a significant driver of economic growth in the past 40 years.