Monday, August 10, 2020
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Liquidity, Short Covering, Not Profits Are Driving Markets


It is well understood that the primary reason behind the stock market rally is the unprecedented amount of monetary stimulus from the Fed and other Central Banks.

The gigantic short position was squeezed by the rising market causing panic buying to cut losses.

M2 money supply is up 40% alongside the same increase in the Capitalization value of the S&P 500. 

The market is trading at 20 times 2019, S&P 500 earnings of $162.30. The highest recorded. Forecasts of 2021 earnings are all over the map, but I am guessing they could come in around $125.00. Meaning the market is trading around 25 times 2021 expected earnings. I think this earnings estimate could be too optimistic because there is no question that the economy is in a full scale depression, not just a recession. Recovery is going to take years.

If we apply a generous 17 multiple to 2021 earnings, some two years in the future, it would take the S&P 500 down to $2125, from the closing $3190.00 yesterday, a decline of about 33%. A 17 multiple is quite generous in a slow growing high unemployment economy. The bottom could be a 15 multiple for a decline of 41%.

It is estimated that 3rd quarter GDP will be down approximately 50%, the greatest decline ever. If you do the math, to recover to pre-virus levels, GDP would have to double. I think this is impossible even if a “V” shaped recovery occurs. If the GDP shrinkage is an optimistic 25%, it would have to increase by 33%.

The Trillions of stimulus injected into the economy exceeds the stimulus injected over the 11years since 2009. The central banks have indeed fired a bazooka of stimulus and promise to keep doing so “as needed”. The National debt has increased by 50%.

The problem is that very little of the monetary expansion finds its way into the main street economy. The major recipients are the financial institutions and Wall Street. The stimulus inflates the value of all financial assets to levels not justified by business conditions, setting up investors for painful loss.

The separation of market values from the main street economy has increased the risk to investors and has made price discovery illusive.  Price discovery is essential to ascertain whether an investment has merit. It is non-existent today but the Mr. Market drives higher on an ever greater supply of liquidity, hope, speculation and FOMO.

The Trillions of borrowed stimulus will unlikely grow the economy in the usual way. It is a stopgap measure to replace lost incomes and revenues due to the shutdown. It is scheduled to cease at the end of July, in the hope that the recovery will swiftly restore revenues and jobs by that time. However, the virus has been accelerating in those states more aggressively opening up.

The crunch will come in the fall when it will be possible to ascertain the devastation inflicted upon the economy and measure the rate of recovery during the 3rd and 4th quarters. In the meantime, the markets, instead of seeking good news, might celebrate “less bad news”.

As an aside, I think double digit unemployment could prevail for several years. This possibility is very disturbing because there is so much public unrest in the US.  Adding a difficult economy to the mix could trigger more riots and civil disturbance.

Trump has been very good for the markets. The polls indicate that he and the Republicans are many points behind Biden and the Dems in the Senate. The Dem’s policies are not market friendly and unless the polls improve for the Republicans, the markets will begin to adjust lower after Labor Day.

The extreme valuation of the S&P 500 is based on a perfect storm of good news:

1.    No recession.
2.    The recovery will be “V” shaped.
3.    A vaccine is discovered by the fall.
4.    The Polls are wrong and Trump will win in November.
5.    There will be no second wave and will be contained anyway. (Florida just reported 8,525 new cases following 3 days since opening up)
6.    Corporate profits will fully recover.
7.    Labor conditions will recover.
8.    Another Fed bail out is in the bag.
9.    The riots have no impact
10.    The damage to the economy is temporary.

Clearly, there is considerably more bad news to follow due to the impact of the shutdown of the global economy and the fact that a recession was underway back at the end of February. I think market valuations are ridiculously overpriced and a more severe decline is on the way.

Speculators are betting on a “V” or “U” recovery. My bet is that it will be a straight line for the markets at 180 degrees straight down.

Our portfolios are ready to take advantage of any opportunity.

Our cash is invested in the US currency, which went against us when oil prices escalated off the lows. However, our poor country is hurting from poor trade with China and reduced trade due to the global shutdown.

Canada's current account deficit rose to CAD 11.1 billion in the first quarter of 2020 from an upwardly revised CAD 9.3 billion in the previous period and compared with market expectations of a CAD 10 billion shortfall. 

Our country is being suffocated by record debt owed by individuals, corporations and all levels of Government. We are running deficits in trade and gigantic budget deficits across the nation. These conditions typically cause the currency to weaken.

The last time we faced this situation, the Government introduced the 7% GST.

Albertans should anticipate both a higher GST and a provincial sales tax. We cannot borrow our way to prosperity.

This note doesn’t contain much good news other than our portfolios are in an excellent position to take advantage of any opportunity.

Sincerely,
Bruce Sansom
Global Wealth Builders Ltd.

P.S. Since writing this note, the market crashed by 6.00% today as investors lose confidence in the Fed and respond to accelerating cases of the virus.

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