The Hallmark of a Bubble, The Long Term Consequences of Massive Government Stimulus and Bank Earnings
Yesterday, the great Howard Marks came out with one of his memos. I consider Marks one of the Top 15 investors of all-time and I try to read most of his memos. Yesterday’s memo, “Coming Into Focus” (https://www.oaktreecapital.com/docs/default-source/memos/coming-into-focus.pdf), was one of his best ever in my opinion and I want to touch on some of the points he made.
First, he made the point I made a couple months ago in “A Tale of Two Stock Markets – The Internet Economy Versus The Real World Economy” (https://www.topgunfp.com/a-tale-of-two-stock-markets-the-internet-economy-versus-the-real-world-economy/) about the bifurcated nature of the current stock market. The pandemic has accelerated a shift towards technology and online and away from brick and mortar and in person services: “The adoption of technology has been pulled forward by the pandemic. Thus virtual meetings, ecommerce and cloud computing are now commonplace, not the exception” (8). In my Client Note, I went on to say that tech stocks were uninvestable because of valuation despite great fundamentals while real world stocks were uninvestable because of terrible fundamentals.
Marks picks up on the former point about tech stock valuations, comparing them to the Nifty Fifty:
Fifty years ago, the Nifty Fifty appeared impregnable too; people were simply wrong. If you invested in them in 1968, when I first arrived at First National City Bank for a summer job in the investment research department, and held them for five years, you lost almost all your money. The market fell in half in the early 1970s, and the Nifty Fifty declined much more. Why? Because investors hadn’t been sufficiently price-conscious. In fact, in the opinion of the banks they were such good companies that there was “no price too high”. Those last four words are, in my opinion, the essential component in – and the hallmark of – all bubbles. To some extent, we might be seeing them in action today. Certainly no one’s valuing FAAMG on current income or intrinsic value, and perhaps not on an estimate of EPS in any future year, but rather on their potential for growth and increased profitability in the far-off future (9)
Yesterday, the WSJ’s ace tech stock reporter Dan Gallagher wrote a column about Zoom (ZM), which is the poster child for “no price too high”. ZM closed today (Wednesday 10/14) at $509, up 638% YTD. ZM now has a market cap of $151 billion and is trading at 63x this year’s sales guidance and 209x this year’s EPS guidance given on 8/31 (https://investors.zoom.us/news-releases/news-release-details/zoom-reports-second-quarter-results-fiscal-year-2021). I don’t really know what to say about those metrics. They are beyond insane.
The last point Marks makes in his 16 page memo that I want to touch on is the potential consequences of the government’s massive stimulus response. Here’s the list of things he’s worried about (12):
– federal deficits and debt
– rising interest rates
– inflation
– $ weakness
– downgrade of US credit rating
– the loss of reserve currency status of the $
Unfortunately, Marks is not wholly consistent in drawing out the conclusions of his analysis. For one, he called the policy response “brilliant” (13) despite his list of long term concerns. How is the policy response brilliant when it’s increasing the probability of all these potentially dire long term consequences? What a ridiculous thing to say in light of his previous analysis. Yes: the policy response has worked to prop up financial markets in the short term. But what about the long term consequences? “The art of economics consists in not looking merely at the immediate but at the longer effects of any act of policy” – Henry Hazlitt, Economics in One Lesson. I can’t believe Marks thinks the policy response was “brilliant”.
Second, he says that the policy response has created “the lowest prospective returns in history” (15) but argues against going to cash and waiting for a better environment because such an action is “extreme and certainly not called for now” (15). How is going to cash an extreme response to “the lowest prospective returns in history”?
Along the same lines, despite his analogy of tech stocks today to the Nifty Fifty, he concludes by writing: “The case isn’t extreme – prices aren’t grievously high” (16). What? He just argued that they were, writing that “no price too high” seems to be the current attitude towards tech stocks.
In conclusion, Marks is one of the Top 15 investors of all-time and this is one of his best memos but he seems loathe to draw the full conclusions of his analysis.
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Next, I want to talk a little about this week’s bank earnings. JPM C WFC BAC and GS all reported earnings the last two days (Tue 10/13 and Wed 10/14) and the market reaction has not been good. Why? Each of the Big 4 commercial banks reported greatly reduced provisions for credit losses – but that was widely expected. What was not expected was the hit they are taking on net interest income. Net interest income decreased by 9% at JPM, 10% at C, 17% at BAC and 19% at WFC. That’s because, with interest rates so low, banks simply can’t earn a good spread on the interest they must pay for money and the interest they receive on their loans. JPM is down more than 2% since reporting earnings and C BAC and WFC more than 5%. GS’s results were the best received as investment banking remains strong in this rip roaring market – though the stock was only up 0.2% today.
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Those of you with margin accounts will be happy to know that, as of last Friday’s open (10/9), I have covered all of our stock shorts. That’s because even though this is a massive bubble, I don’t believe it is ready to pop yet. I’ll be looking for a spot to reenter on the short side but will be practicing much tighter risk management next time around should I do so.
Greg Feirman
Founder & CEO
Top Gun Financial (www.topgunfp.com)
A Registered Investment Advisor
PO Box 837
San Carlos, CA 94070
(916) 224-0113
Stocktwits (55K followers)/Twitter: @TopGunFP
Instagram: topgunfinancialria
A Tale of Two Stock Markets – The Internet Economy Versus The Real World Economy
We are, and have been, in a secular shift away from physical living towards online. I recently read a tweet that said COVID-19 has massively accelerated this trend. Earnings reports from the last couple of weeks have borne this out. Let’s take a look at four stocks to illustrate what’s going on: Amazon (AMZN), Shopify (SHOP), CSX (CSX) and Caterpillar (CAT). The former are going gangbusters while the latter are barely surviving.
Let’s start with AMZN, which reported earnings Thursday afternoon. It was one of the best quarters I’ve ever seen with revenues up 40% and EPS 97%. I know that I am buying a lot more from AMZN during COVID-19 and clearly so is everyone else.
The same thing applies to SHOP, which sells online store platforms to businesses. Revenues were up 97% and they reported their first quarter of real net income with EPS of $1.05.
Now, let’s turn to the real economy stocks, starting with railroad CSX which reported earnings two Wednesdays ago. Volume was down 20% and Pricing 7% resulting in a 26% decline in revenue and a 43% decline in net income.
CAT’s report last Friday morning looked similar to CSX’s. Revenues were down 31% (40% in North America) and EPS 70%.
And, as we all know, Tech is leading this market because of its stellar fundamentals. QQQ is up more than 20% YTD compared to the S&P which is flat. As a result, investors are piling into Tech.
The problem with Tech is valuation. The Big 5 are now trading at 31x 2021 EPS estimates. AMZN and SHOP are even more extreme. Even giving AMZN credit for its net cash position (cash plus cash-like securities minus debt), it’s trading at an EV / TTM EPS multiple of ~120. I love Amazon. I shop there all the time. I even have an AMZN credit card to maximize my points when I shop there. But that valuation cannot be justified. It means that it would take you 120 years at the current rate of earnings to get your investment back.
SHOP’s valuation is even more insane. Also giving SHOP credit for its net cash position, it is trading at an EV / TTM Revenues of ~60x. That means that, assuming SHOP had no expenses, it would take 60 years to get your money back! Of course, the assumption of no expenses is ludicrous as SHOP has to pay employees, rent, taxes, etc.. This kind of valuation is pricing in not world but galactic domination!
That’s why I think this market is uninvestable right now. Either you buy Tech stocks with stellar fundamentals benefiting from an accelerated secular shift to online at valuations that can never be justified or you buy real economy companies whose businesses are being decimated. Head you lose, Tails you lose IMO. That’s why I’m shorting this market. It’s the only thing that makes rational sense.
Greg Feirman
Founder & CEO
Top Gun Financial (www.topgunfp.com)
A Registered Investment Advisor
P.O. Box 837
San Carlos, CA 94070
(916) 224-0113
The Great Disconnect and The Fed Put
Everyone can see and feel that this is different and can sense the bizarre nature of the market response: we are in the top 10% of historical price earnings ratios for the S&P on prior earnings and simultaneously are in the worst 10% of economic situations, arguably even the worst 1%! – Jeremy Grantham, GMO 1Q20 Letter (https://www.gmo.com/americas/research-library/1q-2020-gmo-quarterly-letter/)
There were three notable earnings reports this week and each of them confirmed the insane disconnect between the real economy and the financial markets. On Wednesday afternoon, KB Homes (KBH) reported earnings for the quarter ended 5/31/20. New orders were down 57% for the quarter and while the stock dropped 12% today, it is still only 25% off its bull market highs. This morning (Thursday), Darden Restaurants (DRI) reported earnings for the quarter ended 5/31/20. The most significant data point from the report, in my opinion, is that comps for the first three weeks of June, through Sunday 6/21, were -33.2%. While it makes no sense to me, the stock jumped almost 5% and is up more than 100% from its March lows. Finally, Nike (NKE) reported earnings for the quarter ended 5/31/20 after the close today (Thursday). Revenues were down 38% and they lost 51 cents per share. The stock finished the after hours down 4% but is still only $8 off its all-time highs!
The main cause of this disconnect between the real economy and financial markets is the massive injections of liquidity by the Fed. In an excellent piece from Tuesday (https://www.fidelity.com/learning-center/trading-investing/markets-sectors/market-rally-2020?ccsource=email_weekly), Fidelity’s Jurrien Timmer, Director of Global Macro, argued that this is why the current rally, while similar to the one from 11/13/29 to 4/17/30, is unlikely to be a bear market rally in a Second Great Depression: “Because of support from the Fed, I don’t see a repeat of the 1930s happening today.”
Timmer makes an excellent point that the policy response today is vastly bigger than the one at the onset of the Great Depression. However, he fails to ask the next question: What are the potential unintended consequences of such a massive and unprecedented injection of liquidity by the Fed? You don’t just inject $3 trillion into financial markets and the real economy (via loans to real companies) in three months without consequences. There are two that standout to me as highly likely. The first is the creation of asset bubbles. It is my firm conviction that the stock, bond and commercial real estate markets are all in enormous asset bubbles. The second is inflation. While most of the Fed’s money is going into financial markets, a significant chunk is being loaned to real companies who can spend it in the real economy, which could cause inflation. It’s no surprise that gold is testing $1800/ounce and investors are piling into gold ETFs.
For these reasons, I disagree with Timmer that this is not a bear market rally. The Fed’s injections have massively distorted financial markets and caused extreme bullish psychology. However, that is not the foundation for a genuine bull market in which previous excesses have been cleansed from the system, valuations are cheap and the stage is set for innovation and productivity growth. The great disconnect clearly shows that the stock market rally is artificial and it is my belief that unintended consequences will emerge shortly that will derail it.
Greg Feirman
Founder & CEO
Top Gun Financial (www.topgunfp.com)
A Registered Investment Advisor
P.O. Box 837, San Carlos, CA 94070
(916) 224-0113
The Top Is Probably In
Let’s flashback to March 2000 when the Dot.com Bubble topped. The NASDAQ closed above 5,000 twice – Thursday 3/9 and Friday 3/10. And that was it. Today, the NASDAQ closed above 10,000 for the first time. Because of human psychology, these round numbers are important. You very frequently see the indexes find support and resistance at them.
But even more significant was today’s action post-Fed. The Fed made a very dovish announcement, saying that they intend to keep the Fed Funds Rate at 0% through 2022. At first, markets surged higher but it was short lived as they sold off into the close, with the NASDAQ finishing marginally higher than before the Fed and the S&P actually finishing lower. In other words, J-Pow once again fired his “bullzooka” but it did not work.
Now let’s flashback to the 2007 topping process. The S&P made an initial top on 7/19/07 with an intraday high of 1555. Then, a couple of Bear Stearns hedge funds invested in subprime mortgage backed securities blew up, investors realized that many other funds as well commercial and investment banks were exposed to these securities, and the market cratered for a month, finding an interim bottom of 1404 intraday on 8/15/07. From there, the S&P rallied back, making a marginal new intraday high of 1565 on 10/9/07. And that was it (See my “Revisiting The 2007 Topping Process” (4/27/20): https://www.topgunfp.com/revisiting-the-2007-topping-process/).
Something very similar could be happening with the NASDAQ, which is where all the action is, right now. The NASDAQ made an initial intraday high of 9,838 on 2/19/20. Then we crashed into the 3/23 low from which we rallied back to an intraday high of 10,087 post-Fed today.
Let’s dig a little deeper into the market action the last couple of days. Breadth has been bad with Advancers to Decliners on the NYSE + NASDAQ 1980/4354 today and 1796/4513 yesterday. Crucially, the only S&P sector to close higher the last two days was Tech; every other S&P sector was down. In other words, this market is very thin; that is, the only thing really going higher right now is Tech.
In fact, 7 stocks with the acronym FANGMAN (FB AMZN NFLX GOOG GOOGL MSFT AAPL NVDA) are driving the entire market, making up more than $6 trillion of the NASDAQ’s approximately $20 trillion market cap. Keep your eye on these 7 stocks: When they crack, it’s GAME OVER.
So far, I’ve been talking pure technicals. But let’s not forget that this is absolutely a bubble. That is, there is a massive disconnect between the market and the economy. GMO’s Jeremy Grantham said it best when he wrote in his 1Q20 Letter: We are in the top 10% of historical price to earnings ratios for the S&P on prior earnings and simultaneously are in the worst 10% of economic situations, arguably even the worst 1%! (https://www.gmo.com/americas/research-library/1q-2020-gmo-quarterly-letter/). This was borne out yesterday when Tiffany (TIF) reported that global comps for May were approximately -40% and Starbucks (SBUX) said this morning that May US comps were -43%.
Greg Feirman
Founder & CEO
Top Gun Financial (www.topgunfp.com)
A Registered Investment Advisor
825 San Antonio Road #205, Palo Alto, CA 94303
(916) 224-0113
America on the Brink
George Floyd died at a moment of extreme dysfunction in American political life. Relations are so poisonous and so polarized between the parties that we are not seeing the kind of bipartisan meetings on Capitol Hill that typically occur at times of crisis. Hence, the feeling of things spiraling out of control – Business Historian Ron Chernow, quoted in Gerald Seib, “Virus, Unemployment, Riots: When Shocks Multiply, The Effects Usually Last”, WSJ, 6/2
A health crisis, an economic crisis, and a racial crisis have converged to produce a clear and present danger to American democracy – William Galston, “I’ve Never Been So Afraid for America”, WSJ, 6/3
Last night, I was sitting in my car reading at Carlmont Center in Belmont, CA, about 5 minutes from my home in San Carlos, when I received a text from my Mom that, due to a race protest that afternoon in neighboring Redwood City, San Mateo County had implemented a curfew starting at 8:30pm and running through 5:00am this morning. As I drove home, I saw high school kids carrying signs reading things like “We will not be silenced”. I’ve never seen anything like this in the affluent area where I live. It was quite disconcerting.
The sadistic murder of George Floyd by Minneapolis police officer Derek Chauvin has inflamed racial tensions that go back to the country’s founding and added one more crisis to a growing list. The murder has caused riots and looting across the country with no end in sight. Both Gerald Seib and William Galston compare the current situation to 1968. As if we weren’t already dealing with enough crises!
Just before Floyd’s murder, it seemed as if the country was beginning to recover from the coronavirus. While by no means contained, states had started re-opening their economies under political pressure to balance the public health against the economy. California began Phase 2 of the re-opening on Friday, May 22 and other states seemed to be following a similar trajectory. Economic activity began to pick up from extremely depressed levels. For instance, Lyft (LYFT) reported yesterday afternoon that rides in May were up 26% from April – though still down 70% from a year ago.
Another brewing crisis is the growing tension between the world’s two superpowers, The United States and China. The “Chinese Virus” added impetus to Trump’s attempt to bring manufacturing jobs back from China. It now seems inevitable that many supply chains will be removed from China but not without costs: “US security hawks should be aware that a broad-based attempt to disentangle the two countries’ supply chains and educational linkages will come at a significant cost to America’s own competitiveness” (Nathaniel Taplin, “A US-China Breakup Will Be Pricey for Both”, WSJ, 6/3).
Even more important is the stock market bubble which continues to inflate by the day – the S&P is up 9 days in a row now. Many investors and commentators are astounded by the disconnect between the stock market and the economy. A narrative of a V-shaped recovery combined with massive injections of liquidity by the Fed have created bullish crowd psychology unparalleled in history. The closest historical analogy is the Dot.com bubble but the current bubble is far broader in scope, encompassing not just tech stocks but the entire stock market, government and corporate bonds and commercial real estate.
The stock market has never been more important to the American economy. That’s because the economy is now structured into two classes of people: the “managerial elite” (James Burnham) or the “overclass” (Michael Lind) which make up about 20% of the population and the Service/Gig workers who serve them. The Top 20%’s spending is highly dependent on the wealth effect. That is, as their financial assets grow, they spend more on discretionary purchases like restaurants, travel, clothes and other such purchases. However, the reverse is also true: Were the stock market to deflate, the wealth effect kicks into reverse causing the wealthy to spend less on these discretionary items, hitting employment and income for The Bottom 80%. The middle class, historically the American economy’s strength, has been hollowed out by the outsourcing of manufacturing jobs to countries with cheaper labor like China. Therefore, when this bubble pops, it will decimate the economy, with The Bottom 80% bearing the brunt of the pain.
On top of that, the Fed’s massive policy response – a $3 trillion increase in their balance sheet since the onset of the coronavirus – threatens the dollar with a currency crisis. As we all know from Econ 101, an increase in supply, ceteris paribus, results in a decrease in price. When applied to the current case, that means the Fed’s policies are devaluing the dollar. The dollar is just a piece of paper, not backed by anything i.e. fiat currency. Its acceptance as a medium of exchange is therefore based on confidence. If the Fed continues to dilute the purchasing power of the dollar by creating more and more of them, confidence, that delicate thing, could be lost. In that case, inflationary psychology could take hold making economic calculation difficult and causing an increase in interest rates among other things. The modern global economy depends on the dollar to function as a medium of exchange. Should people begin to lose confidence in it, it would result in at least a Second Great Depression if not Civilization Breakdown (see my “The Possibility of Civilizational Breakdown”, 3/19).
Right now, the world is focused on the race riots and the coronavirus. However, while important, the more serious threat is the stock market bubble and the Fed’s policy response to the coronavirus. Should the stock market bubble pop, as I said previously, the wealth effect will kick into reverse, devastating the economy. Were that to happen, however, Fed Chair Jerome Powell has proven that he will not hold back. He will continue to fire bullets in the form of asset purchases, ballooning the Fed’s balance sheet, and threatening a currency crisis. Make no mistake about it: this is the biggest bubble in world history and when it pops, the race riots and the coronavirus, while still important negatives, will take a back seat to the ensuing economic collapse. America is on the brink and we have crossed the line of no return. The clock is ticking and it is only a matter of time now.
Greg Feirman
Founder & CEO
Top Gun Financial (www.topgunfp.com)
A Registered Investment Advisor
825 San Antonio Road, Palo Alto, CA 94303
(916) 224-0113
Stocktwits (55k followers)/Twitter: @TopGunFP
Instagram: topgunfinancialria
Revisiting The 2007 Topping Process
“Tops are a process; bottoms are an event.” —Source unknown
I started Top Gun in 2006 to capitalize on my conviction that the bursting housing bubble would cause a nasty recession. 2006 was spent creating my website, studying and taking the Series 65, applying to the State of CA for my RIA (Registered Investment Advisor) license, finding office space and in general getting everything set up. I went live managing money on Jan 1, 2007 with a little less than $1 million AUM. I was 29 years old.
In this Client Note, I want to discuss the topping process in 2007. The market hit a peak on 7/19/07 with an intraday high of 1555. It then crashed for a month in the wake of the blowup of two Bear Stearns hedge funds invested in subprime mortgage backed securities and pressures on other financial firms and investors holding similar securities, making a bottom on 8/15/07 with an intraday low of 1404. Then, to my dismay, the market embarked on an almost two month long rally, making a marginal new intraday high of 1565 on 10/9/07. The narrative behind this rally was that subprime would be “contained”, as then Fed Chair Bernanke said. (The narrative this time is of a V-shaped recovery). I remember being confounded by the rally at the time, in the same way I am by the current one. In my opinion, the current rally is the exact corollary of the 8/15/07 to 10/9/07 rally. After enduring that 2 month rally, I was vindicated when I returned 15% compared to -38.5% for the S&P in 2008. The same thing will happen this time around.
After an 11-year, 400+% bull market, investors have been conditioned to buy the dip. It has worked for 11 years so they figure it will work again this time. Because they also believe this correction is ONLY about the coronavirus, the consensus is expecting a V-shaped recovery once the virus is contained and the market is already looking ahead to that outcome. For why the consensus is wrong, see my “Understanding The Consensus View And Why It’s Wrong” (4/5/20; The consensus view and why it’s wrong). Ben Graham famously said that the market is a voting machine in the short run and a weighing machine in the long run. Right now, crowd psychology is overly bullish due to the incredible bull run we just experienced from 2009 through 2020 and that is driving the market relentlessly higher. However, reality will ultimately set in as the economy and corporate earnings remain depressed for longer than is now expected, causing share prices to come down, ultimately breaking the March 23 low of 2192.
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Sharp declines in market breadth in the past have often signaled large market drawdowns — David Kostin and his team at Goldman Sachs (4/24/20; Goldman says narrow breadth in S&P 500 a bad sign for stocks)
The market is being driven higher primarily by The Big 5 tech companies – Amazon (AMZN), Apple (AAPL), Google (GOOG, GOOGL), Microsoft (MSFT) and Facebook (FB) – which now make up 21% of the S&P’s market cap – a higher concentration than even the top of the 2000 dotcom bubble. Correspondingly, while the S&P is 17% below its February 2000 peak, the median stock in the index is 28% below its peak. That’s because The Big 5, who all report earnings this week, are carrying the entire market. Most stocks in the S&P 500 have not bounced nearly so hard, but with The Big 5 making up such a large % of the market cap of the S&P they are able to carry things for now. Once they breakdown, the entire market will as well. That’s why this week is the most important week of the year so far.
Greg Feirman
Founder & CEO
Top Gun Financial (www.topgunfp.com)
A Registered Investment Advisor
825 San Antonio Road #205, Palo Alto, CA 94303
(916) 224-0113
Stocktwits (55k followers)/Twitter: @TopGunFP
Instagram: topgunfinancialria
Understanding The Consensus View And Why It’s Wrong
The consensus view is that this crisis is all about the coronavirus. Once the coronavirus is contained, markets will bottom, if they haven’t already, and we’ll rally into year end, eventually making new highs as the bull market resumes.
One of the best examples of this point of view is Goldman Sachs. Goldman is calling for a bottom in the S&P around 2000 around the middle of June and then a ferocious 60% rally to 3200 into year end.
(Added 4/6): Morgan Stanley also holds the consensus view claiming that the market has already bottomed, there will be no retest of the lows, and that this is the end of a cyclical bear market within a secular bull market.
Another excellent example of this point of view comes from Gary Savage of Smart Money Tracker in his 7-minute video “Ignore the permabears they will be wrong again” (Thu 3/26) (https://blog.smartmoneytrackerpremium.com/2020/03/ignore-the-perma-bears-they-will-be-wrong-again.html). In that video, Gary makes the analogy of the coronavirus crash to the 1987 crash which, while violent, lasted a very short time after which the secular bull market that started in 1982 continued on until March 2000. Gary believes the same thing will happen this time. He believes the bottom is already in, though it will be retested in the coming weeks, and that this is the best buying opportunity of a secular bull market that has 10-15 more years to run due to being in the early stages of a technological innovation cycle.
Also sharing this perspective is the renowned hedge fund manager David Tepper who told CNBC on Monday 3/23 that he was “nibbling” and that stocks had bottomed or were close to doing so (https://www.cnbc.com/2020/03/23/watch-the-full-interview-with-david-tepper-on-when-stocks-will-bottom-and-what-hes-buying-now.html?&qsearchterm=David%20Tepper).
Finally, the well known member of CNBC’s Fast Money, Josh Brown (“The Reformed Broker”) wrote a blog post on Sunday 3/29 called “Three reasons it’s not 1929” (https://thereformedbroker.com/2020/03/29/three-reasons-its-not-1929/) concluding: “Everyone knows it’s temporary”.
In an exchange with Howard Lindzon on Stocktwits last Monday (3/30) about Josh Brown’s piece, he said the current downturn would last “a few months” while twice calling me an “angry asshole” for my bearish views (https://stocktwits.com/TopGunFP/message/203470866).
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Unfortunately for those who hold it, the consensus view is wrong. In order to explain why I’m going to make a slight digression.
When I was in Philosophy Graduate School at UC Davis (Fall 2003 through 2005), I took a Philosophy of Science class in which I read Nelson Goodman’s classic Fact, Fiction and Forecast (1954). In that book, Goodman uses the example of lighting a match to make an important point. Under normal circumstances, when you scratch a match against the side of the case, the match lights. However, if the case is wet, for example, the same scratch will not cause the match to light.
What’s his point?
His point is that in order for the match to light, you need the catalyst (scratching the match against the side of the case) plus the proper initial conditions. In the latter instance where the case is wet, the scratching of the match doesn’t cause it to light because of the initial conditions.
What does this have to do with the current situation in the stock market and the economy?
Clearly, the coronavirus was the catalyst for the massive selloff we’ve experienced over the last month. Nobody disagrees with that. But the consensus view contains a hidden premise: Before the coronavirus, the financial markets and real economy were strong and would have continued so absent the virus. To use Goodman’s terminology, this how the consensus view sees the initial conditions.
However, as I argued in Part II of “The Everything Bubble and The Second Great Depression” (Jan 2019) and “The Possibility of Civilizational Breakdown” (March 2020), the initial conditions were not strong, even before the coronavirus. For one, financial assets were in an Everything Bubble fueled by 12 years of unprecedented easy money policies from the Federal Reserve (Gary Savage calls the claim of an Everything Bubble “absurd”). Second, the real economy was unbalanced due to massive inequality as a result of the hollowing out of the middle class resulting from the outsourcing of manufacturing jobs to China and other foreign countries with cheaper labor. This cleaved society into the Haves (the Professional-Managerial Elite consisting of the Top 20% of society) and the Have Nots (those in the Service and Gig Economy catering to the Top 20%). For an outstanding deep dive into this divide, see Musa al-Gharbi’s “Disposable People”
(4/1) (https://thebaffler.com/latest/disposable-people-algharbi; also Nelson Schwartz’s book “The Velvet Rope Economy: How Inequality Became Big Business (2020)). Put another way, the match case was wet.
Combining the coronavirus (catalyst) with The Everything Bubble and an unbalanced real economy (initial conditions) leads to a very different conclusion about the depth and duration of the current downturn. In my latest Client Note, “Rethinking My S&P Price Target Under Civilizational Breakdown”, I put the probability of Civilizational Breakdown (think Germany in the early 1920s) at 63.5% and the probability of a Second Great Depression (think The United States in the 1930s) at 36.5%.
In conclusion, I want to say that I am not a permabear. While I have been bearish during the 2009-2020 bull market, that’s because I view it as a massive cyclical bull market within a secular bear market that began in March 2000 – the exact opposite view of Gary Savage. For evidence of this, see the chart on pg. 27 of Jeff Gundlach’s webinar “A Tale of Two Sinks” (3/31) showing that the ratio of the S&P 500 to the price of gold peaked in March 2000 (https://cache.webcasts.com/content/doub001/1296855/content/6eb12e188d39ea9ebfdd866dd60f96aabe006c2e/secured/3-31-2020%20Two%20Sinks.pdf). This suggests to me that the real value of the S&P 500 was lower at both the October 2007 and February 2020 tops than at the March 2000 top.
I love this country. In fact, I believe The United States is the greatest country in history, founded on the Enlightenment principles of reason, liberty (including free markets) and equality. I want to see the country and its citizens do well. And I want to be bullish and hope that once we work our way through the current crisis I can be. My bearishness is not a reflection of a pessimistic or misanthropic psychology; I am not an angry asshole! (LOL) My bearishness is simply a reflection of my best analysis of the current moment.
Greg Feirman
Founder & CEO
Top Gun Financial (www.topgunfp.com)
A Registered Investment Advisor
825 San Antonio Road #205, Palo Alto, CA 94303
(916) 224-0113
Rethinking My S&P Price Target Under Civilizational Breakdown
However, in the ~2 weeks since I wrote “The Possibility of Civilizational Breakdown” (Wed 3/18/20, http://www.topgunfp.
The deflation that we are currently experiencing in the financial markets and real economy is only Phase I. Once the virus is contained and people start venturing out to spend and work, all the new money in circulation is likely to shift us from deflation to inflation (Phase II). I can’t say precisely how long Phase I (Deflation) will last because that greatly depends on the course of the virus and the lockdowns, which we don’t have the data to know yet. My guess is that it lasts ~6 months which would put us at the beginning of September 2020. If that is correct and people start to work and spend again, Phase II (Inflation) is likely to begin. This will cause inflation to increase in the real economy, the dollar and treasuries to fall in price and a likely bottom in stocks. I now believe that bottom in stocks will come between ~1575 (the double top established by the 2000 and 2007 bull markets) and 2200, the recent low from last Monday (3/23).
This is exactly what happened in The Great Depression, though they were slower to act back then. It wasn’t until 4 years in (1933) that the Federal Government confiscated all the gold in private hands, devalued the dollar and began an extensive program of fiscal stimulus. As a result, Inflation (Phase I) was put to a stop in 1933 and we entered Phase II (Inflation). This time around, The Fed and The Federal Government have acted much more quickly to stem the deflationary tide, likely shortening the period of Deflation (Phase I) and moving us to Phase II (Inflation) more quickly.
In sum, the coming crisis is likely to be divided into a short (~6 month) Phase I of Deflation followed by a longer Phase II of Inflation. Stocks should bottom at the end of Phase I, and my new target is 1575-2200, a big change from the 340-680 I put forward in “The Possibility of Civilizational Breakdown”. Don’t celebrate just yet, however. While stocks are likely to bottom much sooner than I previously believed, because of the fall in the dollar, their real value is still likely to decline: “In October 1922 [the share price index] dropped to 3/100ths [of its 1913 value in real terms]” (Ferguson, When Money Dies, pg. 118).
I hope everyone is practicing social distancing, staying at home and, in general, being safe out there while the medical authorities gather the data we need to implement sensible public policy about how, when and where to re-open the economy.
Best Wishes,
Greg Feirman
Founder & CEO
Top Gun Financial (www.topgunfp.com)
A Registered Investment Advisor
825 San Antonio Road #205, Palo Alto, CA 94303
(916) 224-0113
The Possibility of Civilizational Breakdown
Sent to Client Note List members Wednesday 3/18/20 at 8:35pm PST:
14 months ago (Jan 2019) in my Client Note “The Everything Bubble And The Second Great Depression” (https://www.topgunfp.com/the-everything-bubble-and-the-second-great-depression/), I laid out my case for what I saw as an impending depression. The analogy I had in mind was the Great Depression in the United States in the 1930s and I called for a 2/3 to 3/4 drop from peak to trough. However, the arrival of the coronavirus has thrown a monkey wrench into the equation.
While we don’t know how long it will take to contain, the coronavirus is already and will continue to cause significant economic damage. Many places are already Sheltering At Home – including San Mateo County, where I live – meaning that people in all but “essential” businesses cannot go into work and people can only leave their homes for certain authorized activities. This is causing both a supply and a demand shock. While some people and companies can work from home, many cannot. Even for those who can work from home, it will take time to get up to speed and reach previous levels of productivity. On the demand side, with consumers staying home, all brick and mortar retail businesses will see their sales decline dramaticially.
Adding the coronavirus to an 11 year asset bubble and structural imbalances in the economy that I discussed in Part II of “The Everything Bubble And The Second Great Depression” raises the possibility that this bear market will be WORSE than The Great Depression. For the first time, early this morning before the market opened (Wed 3/18) as the SPY suggested the possibility of hitting the first circuit breaker (-7%, ~2352) which coincided with a significant level of support from the December 2018 lows ~2350, my mind turned to Weimar Germany in the early 1920s.
In The United States over the last 100 years, we have had many bear markets corresponding with recessions and one bear market corresponding with a depression. In Weimar Germany in the early 1920s, in the wake of their loss in WWI and the reparations imposed on them by The Versailles Treaty, they experienced something worse: Civilizational Breakdown. In other words, the downturn went beyond the economic realm, destroying the ability of society to function.
Economically, hyperinflation caused by massive money printing to meet the reparation payments destroyed the Mark as a medium of exchange resulting in a reversion to a barter economy. This greatly complicated economic life, enormously reducing economic activity and causing mass unemployment.
But it went beyond economics. Crime soared, women turned to prostitution to feed their families. It also almost certainly played a role in the rise of Nazism and Hitler in the 1930s which led to WWII. I don’t remember all the details but you can find them in Adam Fergusson’s outstanding history When Money Dies: The Nightmare of Deficit Spending, Devaluation, and Hyperinflation in Weimar Germany (1975). (I read the book many years ago and have it in storage. But since San Mateo County instituted Shelter At Home starting Monday at 12:01am, I cannot retrieve it. I ordered another copy from Amazon this morning before the market opened (Wed 3/18)).
Combining the coronavirus with a massive asset bubble and the structural imbalances in our economy could result in something similar happening again. Briefly, the structural imbalance I refer to is the enormous inequality in our society, dividing us into The Top 10% and the rest working in the service and gig economy who primarily service the wealthy. As the asset bubble implodes, a negative wealth effect will kick in, causing the Top 10% to spend less on things like eating out, vacations, and all sorts of discretionary purchases. This will hit the service and gig economy, reducing incomes and causing unemployment. It could become so bad that hungry, unemployed, armed men roam the streets looking for people and businesses to rob and women turn to prostitution in order to survive – the same sorts of things that happened in Weimar Germany in the early 1920s.
While a depression would result in a 2/3 to 3/4 drawdown in the S&P 500 peak to trough in my opinion implying a bottom between 850 and 1133, as I wrote in “The Everything Bubble And The Second Great Depression”, civilizational breakdown would be worse. We could see a peak to trough drawdown of 80% to 90%, which would mean the S&P bottoming between 340 and 680. I know this sounds almost unimaginable, but it happened once before and the arrival of the coronavirus puts this scenario on the table again in my opinion. I believe the odds of a Second Great Depression to be 50% and the odds of Civilizational Breakdown similar to Germany in the early 1920s to be 50% [updated from 77.5% Second Great Depression/22.5% Civilization Breakdown to reflect my views as of Friday 3/20/20].
The market will not go straight down. Things will take time to play out and there will be countertrend rallies, maybe some as big as +20-30%, especially once the coronavirus looks to be contained. But while these will be tradable, they will ultimately be bull traps. Use them to sell into strength and position yourself for years of economic dysfunction or worse.
Americans must start to take the coronavirus seriously by sheltering at home, practicing social distancing, washing your hands almost obsessively, etc… We stand on the precipice of a great cliff that could completely derail our country and Western Civilization. It is time for each of us to be the best version of ourselves, to do the right things, to be compassionate towards others. So much depends on it.
Wishing you all the best in this time of crisis,
Greg Feirman
Founder & CEO
Top Gun Financial (www.topgunfp.com)
A Registered Investment Advisor
825 San Antonio Road #205, Palo Alto CA 94303
(916) 224-0113
The Evolving Late Stage Bull Market
Last week, James Mackintosh had an interesting article in the WSJ about the stealth bear market. His main point was that stocks have essentially gone nowhere since Jan 26, 2018. Digging a little deeper, he points out that the Russell Top 50 Mega Cap Index is up over 5% in that period while the Russell 2000 as a whole is down 3.6%. In other words, it’s the very large stocks that are now driving this thin market. If you look at the charts, the biggest 5 stocks (Facebook, Apple, Amazon, Google and Microsoft) are having monster years, but many stocks are not keeping pace.
Mackintosh followed up his article on the stealth bear market this week with one on WeWork and investors shift from seeking growth at all costs to profitability. WeWork’s massive losses caused the company to essentially blow up during the IPO process, going from a valuation of $47 billion to $8 billion. According to Mackintosh, that’s because investors are no longer willing to pay up for fast growing, money losing startups and instead are focusing more on profitability.
This analysis seems borne out by recent reactions to 3rd quarter earnings reports. Wednesday afternoon, stalwarts Apple and Facebook reported solid, profitable quarters and the market rewarded them, even though they are already up significantly this year. Apple’s numbers were essentially flat, but that is good enough for a company whose business model is evolving away from complete dependence on a saturated smart phone market and towards wearables and services. Facebook’s revenue was up 29% and operating income 24%. Tesla’s stock operates according to different dynamics but it got an enormous boost when it reported a surprisingly profitable quarter despite an 8% decline in revenues.
On the other hand, Amazon struggled a bit as 1 day fulfillment added to retail costs and competition from Microsoft and others slowed AWS operating income growth to 9%. Similarly, Google reported strong top line growth of 20%, but increasing expenses hit profitability and caused a slight selloff in the stock.
More broadly, money losing recent IPOs have not fared well. Uber and Lyft are the most obvious examples. Both are trying to grow market share at the expense of current profitability and the market isn’t having it.
All this suggests that investors are aware that the bull market is in the later stages and are looking forward to the end of easy financing. If these companies can’t finance themselves through venture capital or bond offerings, their lack of profitability makes it impossible for them to finance themselves internally. The recent outperformance of value also supports this interpretation.
The food delivery space offers a vivid illustration of this dynamic. Grubhub reported 3rd quarter earnings on Monday afternoon and 4th quarter guidance showed that competition is heating up. Investors were caught off guard sending shares down 43% on Tuesday. The reason is that private DoorDash and Uber Eats have enormous war chests that are enabling them to operate at a loss in an attempt to gain market share. This is destroying profitability for the whole industry as Grubhub’s results showed. “We now view this as a race to the bottom with no clear winners” analyst Robert Mollins told the WSJ.
Trends evolve and the shift away from growth at all costs to profitability and the thin mega cap market leadership may not persist. However, in my estimation, these new wrinkles suggest that investors are concerned that the bull market is entering it’s end stages and are positioning accordingly. After 10 1/2 years of a relentless bull market, many are still scared of missing out (FOMO), however you can’t catch the very top and these shifts suggest to me that much of the smart money is shifting its positioning. We may be in the kind of market where you have to pick up pennies in front of a steamroller, as Mark Minervini is fond of saying, as opposed to the long uptrending bull market we experienced from March 2009 through January 2018.
Greg Feirman
Founder & CEO
Top Gun Financial (www.topgunfp.com)
A Registered Investment Advisor
(916) 224-0113
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