Apr 20, 2020
“Stock market bubbles don’t grow out of thin air. They have a solid basis in reality, but reality distorted by a misconception” George Soros
Recessions always have that initial pop. The bubble-bursting realisation that perhaps the easy money wasn’t so easy after all.
In 1819, US banks would hand out unsecured loans to land developers for land that turned out to be worth nothing but dirt, causing the banks to fall to the ground and the economy to fall with them.
In 1857 railroad pioneers (the start-ups of the mid nineteenth century) were receiving huge amounts of debt for nothing but the promise of a new railway. Many of these companies never bought a single physical asset required for the construction of a railway but their values still skyrocketed. Pop.
Then we reach comparatively modern times and the more familiar shocks.
Think 1929, where investors saw the entire stock market as a get-rich-quick scheme. 2001’s dot-com bubble where you saw 74% stock price rises for changing your company’s name to associate with IT or 2008 where you could bundle up a bunch of junk contracts and stamp them with a gold star AAA credit rating.
The recurring theme here is financial momentum. In particular, industries pushing organisations into being less organised and increasingly overleveraged and overvalued.
So what’s different about our current situation? The buzz word of the last month has been ‘unprecedented’. And it is, for a variety of reasons. One of these differences is that instead of this economic downturn being started by a particular industry or business sector, it was instead created by a fast-spreading worldwide virus, COVID-19. Whilst businesses are responding in various ways on the frontline, more time is needed now to determine if the economic recovery will follow the recovery rate of the world’s health.
If COVID-19 was the push of the first domino, a worthwhile consideration is, “What else could, or already has begun, to fall over?”. We live in an increasingly connected and interdependent global economic system. This means that more than ever before, economic shocks are prone to disrupting all markets.
Two topics at the forefront of my mind are:
1. Corporate debt. The U.S. has $15.5 Trillion of corporate debt, 74% of the country’s GDP.
Corporate debt is graded on a scale of ‘riskiness’ (see table) and there are three main ratings agencies: Moody’s, S&P and Fitch.
One particularly startling fact is that just over half of all new investment grade bonds were rated BBB, the lowest investment grade rating available. This build up has been driven by historically low interest rates.
It is no surprise that being seen as less creditworthy comes with its disadvantages. It is more challenging to receive financing and you have to pay a higher rate of interest than your more trusted peers for the privilege of borrowing money.
Well, what happens to your company when your profits have been declining for years already and suddenly a new virus means you have to lock up the shop for months? Let’s use an example. Since the pandemic, Ford’s $36 Billion of debt has been downgraded to ‘junk’. Lower sales, lower profits and every factory world-wide is shut. Now when their debt comes due, how do they pay it back? They’re going to have to take on new debt to pay back their old debt, the only difference now is that this debt is going to be more expensive because it’s more risky and you don’t need an MBA to discern that the last thing a company with decreasing sales needs is increasing expenses (from debt servicing).
2. Unemployment. In the four weeks since COVID-19 has hit, 22 million unemployment claims have been filed in the US.
The incentives are high for those made unemployed to file the claim. Each state has its own unemployment compensation scheme in addition to that of Congress, which guarantees an additional $600 a week — starting from the date a person files their claim.
But no-one can secure either payout unless their application has been processed and approved by the state’s system. So what could this mean for the figures? I think the actual number of unemployed far exceeds the reported number and that the ~6.6million claims is not the extent of the unemployment itself, but rather a representation of the processing capacity, given reports of websites crashing and jammed phone lines.
Not to mention how personally damaging it can be for these individuals to lose their jobs, the wider economic impact of such a drastic change can reverberate throughout the global economy.
The unemployed are unable to purchase as many goods and services which can cause a negative multiplier effect. This is when a decrease in unemployment leads to an even larger decrease in unemployment because people spending less puts other people’s jobs at risk too. If we go back to thinking about COVID-19 being a domino effect on the economy, then think of robust employment as one of the first dominoes to be knocked over.
The stock market does not accurately reflect the current state of the economy. In 2019, the S&P 500 rose ~30% but the underlying earnings of these 500 companies was nearly flat. In fact, between 2012–2019, the combined profit of all US businesses did not grow whatsoever.
Despite this, the aggregate US stock market doubled during that same period. If you think that’s insane, you wouldn’t be wrong. What could possibly have caused this? A little financial wizardry called share buybacks and multiples expansion. Not sure what these are? Not to worry, here’s a quick example of how my own mythical company Guy Matthews LTD (GM) would increase in value by augmenting its capital structure with cheap debt and fewer shares.
My hypothetical business is small, making only £100 of total profit a year. It has 5 shares, so ‘earnings per share’ (EPS) is £20. Now suppose GM has a Price to Earnings ratio (P/E) of 10x. Each share is worth £20*10x, or £200.
But in this economy with low interest rates, debt is cheap. So GM decided to get in on the action. It issues some cheap debt which has £10 interest p.a. and buys back 2 of its shares from the shareholders. Now, GM has only £90 of profit, and only 3 shares. Now, however, each share receives 90/3, or £30 of earnings per share. What a fantastic return on your investment, with the same 10x P/E ratio one share is now worth £300. This is share buyback.
But we’re just getting started, and multiples expansion is even simpler.
Imagine, clever investors see a headline in Forbes about how GM went from £20 of earnings per share to £30. “Incredible! GM must be a growth stock, it has so much future potential and we’re in a huge bull market. Instead of a P/E of 10x, it should be 16x!” Before you know it, with some new investment GM is now worth £30*16x, or £480 per share.
That’s it. Clearly, it’s an oversimplified example, but that’s the process.
The problem with this is the company is now in a more vulnerable position. It’s more susceptible to economic shocks because it’s super leveraged with corporate debt.
Going forward, we’re now going to see a huge reduction in stock buybacks and dividends as companies seek to preserve their cash and reduce their debt levels which have been mounting.
So that’s what happened in the past, and our learning is that more frugality is likely in the near future. But what about right now? Nobody knows and anybody who tells you they do simply doesn’t.
“We have long felt that the only value of stock forecasters is to make fortune tellers look good” Warren Buffett
What we do know is that the current S&P500 at time of writing is only 4% down from last year. This does not reflect the current state of the economy, but it doesn’t have to. The stock market is a forward looking vehicle, reflecting people’s expectations of future events and the performance of the underlying stocks not solely in that year, but future years. The problem with this is that we are still lacking the data revealing the full impact of COVID-19 on these companies. Quarter 1 results are currently being published, helping to give some indication of impact, but for most regions lockdown only began in the latter part of the quarter. Quarter 2 results will be the most telling. What does a few months of potentially zero revenue do to some of these large companies?
Admittedly, the impact will be felt less in the S&P500 and DOW than a similar situation or black swan event would have a couple decades ago. Why? The two largest sectors making up the S&P are Information Technology (20%) and Health Care (16%), two sectors which are maintaining strength even now. A secondary effect could hit the tech/IT sector as their customers start to cut costs, but a similar argument could be made for the stickiness of existing tech solutions within organisations. Changes to internal systems can be challenging to implement.
What we will also see are thousands of successful companies continuing to do well and fresh innovation leading to greater successes post-recovery. Some of the organisations created in 2008/2009 include household names such as Slack, Uber, Groupon and Whatsapp.
One thing to emphasise is that this is not a reflective article because the entire event is continuously unfolding around us. So bearing that in mind, what are a few of the things I’ll be keeping an eye on in the coming weeks and months?
In June, the results will be published from the ‘Comprehensive Capital Analysis Reviews.’ This is when the large banks (Barclays, Santander, Goldman etc.) have their annual ‘stress test’ results announced. Not only will this be relevant from the perspective of understanding how they will perform in various stress scenarios, but it is also a metric by which regulators use to approve capital distribution plans (stock buybacks, dividend increases) which have been curbed recently by most banks.
How the cash-rich organisations are spending their money. This ‘dry-powder’ is sitting at +$2T in unallocated funds (across private equity and individual large corps). On the extreme side of this, Berkshire Hathaway has ~$128B of cash. Warren Buffett (CEO) said he will always keep $20B in cash to protect against shocks. Lets prudently assume then that he will keep holding $40B to weather this current shock as well as keeping the $20B reserve for a future shock. $88B is still a lot of cash. How much? Enough to buy Starbucks.
Consumer spending remained robust throughout 2019, only slowing towards the very end of the year. Will unemployment and reductions in variable pay (bonuses, expected pay rises etc) have a knock on effect here? Even if this isn’t the case, will recession sentiments among the employed push household saving rates higher to the detriment of consumption? Rational consumers are likely to prioritise paying off debt and rebuilding savings instead of spending on recreation and culture. In economics this could be described as a ‘negative wealth effect’.
Changes to supply chains will start to be made when the dust has settled. I’d expect both more stringent scenario testing and improvements to resiliency as well as diversification for those companies who perhaps have previously relied too heavily on manufacturers or providers in certain regions. This will be exacerbated by the US-China trade tensions earlier in the year and whether or not that trade war heats up again. Reports suggest that COVID-19 has caused short term supply chain disruption for 94% of the Fortune 1000 companies and they will now be incentivised to mitigate future turmoil of a similar nature.
The full extent of the impact will vary considerably depending on factors we still don’t know: how quickly a vaccine develops, how quickly the unemployed find their services back in demand and how governments act to pick up the fallen dominoes. In conclusion my thoughts here are a snapshot of the current unfolding situation. Watch this space.