Good Luck Fighting the Fed…

• Bank of America issues “Mea Culpa” – lifting S&P target to 2900
• Stan Druckenmiller says he “underestimated the impact of Fed liquidity”
• Why the market can easily make you look foolish. 

There’s an old saying when it comes to trading…

“Don’t Fight the Fed”

Never has it been more true than this year…

Despite almost every fundamental (perhaps logical?) reason the market should be trading lower… good luck betting on that outcome.

Short-sellers (i.e., those who profit on the market falling) have been killed post the week of March 23. 

They did very well for about three weeks… but would have been wise not to overstay their welcome.

There’s a torrent of liquidity being thrown at this market (more on this shortly) and it’s finding its way to risk assets. 

The market continued its celebration today… despite what remains a highly uncertain economic landscape.

Who Cares about Fundamentals?

Last Friday we received some (potentially) very good news that the market clawed back approximately 2.5M jobs last month.

However, take a look at the chart below.

This shows the aggregate jobs lost since the government forced many consumer-facing US businesses to temporarily close… sending more than 20M people to file for unemployment

Jobs peaked at 153M in February (i.e. with unemployment at a 50-year low of ~3.4%)… only to drop to levels not seen since the last recession. 

As I was saying recently – there’s a lot of work to do over the next few months  – to recover the jobs that were lost. 

Regaining approx 10% is good…. but can we get 50% in three months?

With respect to the latest figures – I read an interview over the weekend with Diane Swonk – Chief Economist at Grant Thornton.

She said not to read too much into the May numbers – emphasizing how these were misclassified by the Bureau of Labor Statistics (BLS).

For example, the BLS noted that for the third month in a row, its data collectors misclassified some workers as “employed not at work“ when they should have been classified as “unemployed on temporary layoff.“

The department added that this irregularity started in March – where the unemployment rate should have been 5.4% vs. 4.4% officially stated.

Furthermore, April’s unemployment rate should have been 19.7% vs. the official 14.7%. And with respect to May – it reality was closer to 16.3% vs. the officially reported 13.3%

But again, does the market care if the numbers are ~3-4% in error (i.e ~4.5M jobs)?

No.

The unemployment number could be as high as “20%”… or as low as “4%”… all that matters is the Fed is there to buy assets. 

It’s Wall Street vs Main Street. 

The BLS also noted response rates to its labor surveys have been lower than usual — a factor that could lead to bigger revisions in the future.  Swonk said: 

“Calling May the end of the recession really does a disservice to the more than 19 million still unemployed and the extraordinary challenges we face as the economy struggles to reopen with the rate of infection still high.”

As an aside (and certainly not the focus of today’s missive) – some feel the curve is flattening based on a log chart – however the number of US cases continue to climb by tens of thousands per day

COVID Cases Continue to Climb

But COVID-19 is now yesterday’s news… situation (virtually) solved from Wall Street’s perspective. 

Let’s talk to what really matters… 

Fed Expands their Program

Neither the number of unemployed or COVID-19 headlines are shaping the market. 

Yes – the market will take any good news – but bad news is mostly ignored. 

The market is very much focused on liquidity. 

And whilst central banks spigots remain full throttle (which is the case) — don’t expect risk assets to meaningfully correct. 

This is why it’s a risky bet aggressively shorting the market. 

Today, we learned the Fed are now willing to throw even more liquidity at the market by extending their loan program. 

The central bank said they are lowering the initially stated minimum loan and raising the maximum that can be borrowed, plus is expanding the loan terms to five years.

Under the new guidelines, the minimum loan now will be $250,000, half the amount under previous versions of the plan. The maximum will now vary by facility but could be up to $300 million from the previous $200 million.

Fed Chairman Jerome Powell recently said the program was “days away” from making its first loan and said the bank was revamping provisions based on feedback received from thousands of sources. From CNBC:

“Supporting small and mid-sized businesses so they are ready to reopen and rehire workers will help foster a broad-based economic recovery,” Powell said in Monday’s announcement.

 

“I am confident the changes we are making will improve the ability of the Main Street Lending Program to support employment during this difficult period.”

In addition to the changes in loan size, the Fed also has extended the repayment period from four years to five years and will delay the repayment period to two years from the original one year.

 

Interest also is delayed for one year and will be LIBOR, a commonly used overnight lending rate, plus 3%. The Fed also will now assume just 5% of the loans, with lenders holding the rest.

To watch the effectiveness of the Fed’s business loan program – keep an eye on this chart. So far, for the previous months, commercial and industrial loans are up 26% year on year: 

Total Commercial and Industrial Loans Change YoY

$30T on Central Banks Balance Sheets

The programs we are seeing from central banks are unprecedented.

For example, last week the Fed’s balance sheet topped $7 Trillion...  up from ~$3.7T about one year ago.

Prior to 2008 – the sum of all assets across every central bank (e.g., Fed, BoE, ECB, BoJ, RBA etc) was less than $4 Trillion. 

The Fed has almost added that amount in two months!! 

What the?

At the time of writing, the Fed maintains the largest balance sheet of any central bank in the world.  Second on that list is the ECB followed by Japan

Source: Bank of America Global Research

In approx 13 years… we have seen a 16x increase in assets held. 

Put together, the aggregate sum of all central bank assets sits just above $26T and expected to reach $30T next year (according to the Bank of America)

With respect to the Federal Reserve – BofA now estimate their balance sheet could be as much as 48% of US GDP by year’s end (where GDP is forecast to be ~$20T).

Therefore, I guess it should not be that surprising we find stocks surging day after day.

Bank of America’s ‘Mea Culpa’

If you had blindly followed the mantra of “don’t find the fed” when the Fed announced their bazooka (at the end of the March) – you would be in great shape. 

But it comes with a couple of big caveats

1/ ignore company fundamentals for at least 12 months; and
2/ completely ignore everything you hear (or see) from Main Street

That’s the leap of faith required… i.e., Fed liquidity will solve all ills (and without consequence).

Because that’s the state of play.

For example, today the S&P 500 added to its ~47% 12-week rally – turning positive for the year (surging on the Fed’s extension to its loan program)

S&P 500 – June 08 2020 – Turns Positive for the Year

Sure… we all get the massive disconnect between both earnings and the ongoing suffering on Main Street…

And perhaps part of that makes it so hard to “embrace” this rally. 

If this rally has caught you off guard… you are not alone. 

I called it as far as 2900…  now I wonder how much more the Fed can juice this.

But it’s not just me… 

Stan Druckenmiller recently confessed he’d missed out on the comeback, not recognizing the strength of the Federal Reserve’s liquidity programs

What’s more, Bank of America issued a “mea culpa” today and boosted it’s 12 month target for the S&P 500 to 2900 from 2600 (still some 300 points below today’s close

“In a Monday note, Savita Subramanian, the bank’s head of equity and quantitative strategy, raised its S&P 500 target to 2,900 from 2,600 and noted that the index’s “meteoric ascent” has been helped by Federal Reserve stimulus”

“Tepid sentiment is the more bullish input into our target; our Fair Value Model and weak estimate revisions are the most bearish,” Subramanian wrote in the Monday note.

“US stocks remain expensive vs. history on most measures except for free cash flow, but attractive vs. bonds.”

On the flip side, Bank of America sees a number of downside risks to the S&P 500 target. Those include cyclically peaked 2019 earnings-per-share, risks of a second COVID-19 wave, US election risks, risks to a snapback in consumption and services, and borrowing from the future to fund today’s growth

Goldman Sachs also withdrew its forecast from 4 weeks ago for a pullback to 2400 — raised their upside target to 3200. 

At some point the market will come up for air… and traders will lock in quick profits. 

That might be this month or next… I don’t know. It might be at 3200 or it could be at 3400. 

But that’s the dip you will want to buy in terms of a better risk/reward. 

Note: it’s still not without risk!

As I wrote over the weekend – I’m personally choosing not to chase this rally… happy to wait for a better buying opportunity.

I was happy riding it to 2800… and that’s when I flattened my (long) exposure. 

My feeling was above 3,000 – the downside risk starts to outweigh any further near-term upside reward. 

And this largely agrees with the new S&P 500 price targets put forward from BoA and Goldman.

That said, I’ve been wrong calling this market from the week ending May 25th (i.e., once we took out the level of ~2900 – the top-end of my expected pullback zone at 61.8%). 

So who knows… maybe we don’t see a pullback and race straight to “3500+”.

It certainly won’t be the last time this market has made me look foolish!

As I wrote on the blog – it was only a month or so ago “experts” such as (but not limited to) Stan Druckenmiller, Warren Buffett, Howard Marks, David Tepper and Goldman’s David Kostin called this market expensive. 

Druckenmiller said he has been “humbled” – underestimating the massive impact from trillions in Fed liquidity.

Bank of America this week issued their “mia culpa” (i.e., we got it wrong)

If there’s one thing I know – the market will make a fool out of you at some point (and in my case – often) 

But how you choose to trade (or value) the market is up to you. 

For example, I personally ran a few discounted cash flow models (over 10 years) for the leading tech stocks last week (using 5-year growth projections from Yahoo!Finance) – and most seemed reasonably valued.

And this echoes the point from Bank of America… citing free cash flow is perhaps the only valuation metric to make sense.

However, if we price the market purely in terms of its forward earnings – the PE is around 22x. 

That’s rich against the 200-year historical average of around 15.5x

Before I close, over the longer-term, things like strong employment, personal income, debt serviceability and earnings will matter… but they don’t right now. 

If the market knows the Fed has its back… then it will be risk-on. 

As to when the Fed eventually decides to withdraw its temporary support – well that’s a great chat for another day. 

Some (like Howard Marks) are already putting that question forward…  but it’s very much a ‘second order’ question. 

All I can say (with a high degree of confidence) is their withdrawal is unlikely to be this year… and perhaps not even next.

And that’s about as far as the market is willing to look… 

ps: I am very much looking forward to writing this blog in approx two-three years from now… as we start to see some of the unintended consequences of these actions. But in the very near-term – these don’t matter. 

Regards
Adrian Tout