Star Magnolia Capital
Monthly Global Views - The America Drift (July 2020)
The America Drift
By Star Magnolia's Analysts (Penny Shen and Jiawei He)
In the past few months, we witnessed the greatest volatility in the stock market in history. Before March 2020, even Buffet had only seen the market circuit breaker once in his 90-year lifetime, however, many young analysts and traders saw 4 times of circuit breaker in 10 days during the COVID-19 sell-off. Some investors might feel like it was nothing as stock market rebounded strongly and the COVID-19 seems to be fading away in the US. All of sudden, it seems like nobody cares that much about the deadly virus. But the second wave just made things more dramatic. Many people call it “riding on the roller coaster”, but I would prefer to quote a movie (“The Fast and the Furious 3: Tokyo Drift”) to name the scenario, the America drift, not necessarily because of the movie itself, but the drifting as an activity.
As we know, drifting is a driving technique where the driver intentionally oversteers, with loss of traction, while maintaining control and driving the car through the entirety of a corner. The technique causes the rear slip angle to exceed the front slip angle to such an extent that often the front wheels are pointing in the opposite direction to the turn. By using the technique, racers can pass the corner in a faster speed. But to achieve this, they have to find the right turning point for the front wheels to balance the movement of the body of vehicle, otherwise the car will go off track, which is more dangerous and easier to lose control compared with roller coaster. I believe it is a more precise and accurate description for what we are going through now, because apparently the recovery of stock market and surging prices do not reflect the economic problems ahead, plus the second wave of COVID-19, there is too much uncertainty awaiting. The Fed or the US government is the driver this time, to balance the movement of economy under this extreme condition, can they find the perfect fraction for the wheels?
Despite a slew of bleak economic data — including more than 40m Americans filed for unemployment benefits and an expected record contraction in the eurozone economy in the second quarter — the S&P 500 has surged almost 40 per cent since its trough in March, leaving it down just 7 per cent for the year. The index is now trading at more than 22 times expected earnings for the next 12 months, according to FactSet figures, taking the common valuation measure back to levels not seen since the early 2000s. Thanks to the unprecedented speculation from the Fed, over $13 trillion liquidity flooded into the market and scooped up the share price from the bottom.
Meanwhile, we see a second wave of COVID-19 infections all over the world, particularly, in the United States. A second wave of coronavirus has struck some states weeks after reopening — with infection rates spiking in Florida, Texas and Arizona, the country has recorded historic high number for the daily new cases (45k new cases on 27th June). But, unlike the last time, investors remained fairly calm this time and there has been only small correction. And we cannot help thinking about one question, is this normal?
U.S. economic activity has returned to a little more than half of normal activity, according to a weekly measure compiled by Jefferies to track the recovery. A weighted basket of foot traffic, restaurant bookings, traffic congestion, job postings, employee hours spent at small businesses, unemployment web traffic, flight activity, and transit ridership, the index rose to 56% this week from 55% in the prior week, Jefferies says . The biggest boost came from improving foot traffic across U.S. stores. Such traffic is now at 74% of previous levels, suggesting retailers are seeing a quicker swing back to normal compared with other businesses. The Wall Street and the market have been placing their hope on the growth of these numbers, but the reality slapped hard on their faces. With the surge of infections in different states in the US, the reopening would be inevitably reversed. Consequently, the majority of economic activities would likely remain depressed for another 2 or 3 months, which could be horrible if things get out of hands.
Brian O’Reilly, head of markets at Mediolanum International Funds, said stocks had been struggling for direction in the past month, as it had become increasingly clear that the virus would not recede during the northern hemisphere summer. “Covid is still with us and we are still in one of the deepest recessions ever,” he said, noting that investors were taking their cues from the liquidity pumped into financial markets by central banks. He added that US stocks excluding the big technology groups had been knocked in recent weeks, with the equal weighted S&P 500 — a version of the index that is less affected by price movements in the tech groups — down 11% since June 8. “You can make the case that it is a stealth bear market outside of technology,” he said .
It is clear to all investors, the damage caused by COVID-19 would be destructive to the market without the support of the Fed. But the question is, will the Fed spend trillions of dollars every year forever to support the market? The market may become too dependent on the U.S. central bank, which has seen its balance sheet balloon to more than $7 trillion from $4 trillion. Therefore, it is probably the time for investors to take a more cautious approach to select assets.
This time is definitely different from the Global Financial Crisis, because the COVID-19 crisis is not only about the financial industry, but all businesses, it may trigger a series of chain reactions. There has been a wave of bankruptcies totalling billions of dollars of debt since the beginning of April, we will be seeing more of these cases if the situation keeps worsening in the US. The stock market may have gone too far without reflecting the pressure that physical economy is facing. We are not sure if there is bubble in the market, but we are sure investors have a high hurdle for the assets they are buying. As the second wave sweeps across the US cities, the earnings for many companies would have a hard time returning to the pre-COVID level. Many managers have expressed their concern on asset price’s detachment from bleak fundamentals and they are getting ready for another slump in stock markets. For me, the stock market is acting like a vehicle has been drifting for miles without changing tires, it is struggling to find the balance, but when all grains are gone, the tire may just explode and the car will go off track.