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What happens next?

Even if COVID-19 goes away, the economy will not recover in the short term. Thus far in 2020, U.S. stock market circuit breakers have already been triggered four times, which is unprecedented in such a short period of time. Institutions are expecting that when the pandemic slows down and life returns to normal, the U.S. market will rebound into a raging bull market, but recovery may not come so easily.

Focusing on short-term turbulence and neglecting long-term variables is a recipe for disaster. Zooming out is required for context: the magnitude of the collapse in the U.S. stock market has already exceeded that of the European debt crisis in 2012, subprime mortgage crisis in 2018, and the internet bubble burst in 2000. Valuation-wise, S&P 500 P/E ratio fell below the 10-year average of 15.0:

Source: Factset

The sharp decline occurred well before U.S. became the region with highest number of cases. This shows that there are deeper structural factors at play: namely, existing asset price inflation, and the interconnectedness of the US and China (where effects were felt first). The Coronavirus is just the spark that lit the fuse. Prior to the crash in Feb 2020, S&P 500 appreciated by 395% since the end of the financial crisis, making it the longest bull market in the history of U.S. market.

Source: The Market Ear

U.S. corporate debt level, U.S. government debt level, as well as the Fed balance sheet also broke record highs. On the other hand, the annual GDP growth rate was nowhere near as impressive.

How could asset prices and profits grow without appreciable increase in GDP or even an increase in net sales? Financialization. The bull market in the past decade was not primarily driven by economic fundamentals, but rather the continuous balance sheet expansion under low-inflation, low interest rate money policies. The low-rate environment let companies raise large amount of capital at cheap rate to repurchase shares on secondary market. The boost in earnings-per-share pushes up the stock price, creates more opportunities for buyouts and expansions, which further pushes up the stock price. The difference between the compound growth rate of EPS vs. earnings growth rate attributes to share repurchase activities:

Source: Zhongtai Securities

This shouldn't be a surprise to anyone. Wall Street didn't bother to pretend this isn't the case. We know the cause, the question is what is going to happen next?

Source: Visual Capitalists

When the economy fully enters into recession, highly-levered companies' credit ratings will drop, forcing institutional investors such as pensions and insurance companies to clear out their positions. In addition, 14% of the high-yield ("junk bond") issuers are in the energy sector. Companies in oil and gas will have a particularly hard time paying interest on the debt they raised (to do buybacks) with the ongoing OPEC oil price war.

Source: Amundi
Source: Newsnet

What is to be done? The central bankers of the world are currently printing an "infinite amount of money," hoping the rate of easing will slow down the collapse of the dominoes. If the central bankers are determined to print as much as required without caring about inflation at all, although asset prices will stay afloat, the underlying currency will be drastically diluted as a store of value. Savers will be required to search for yield themselves by buying securities or speculating on assets. The general level of financial savvy will need to increase in order for average consumers to preserve the value of their work product—something they've never had to do before.

So what's next? The financialization of Main Street.


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