The World is Flat

-The World is Flat

-There are weapons of mass destruction in Iraq

-The Feds lowered rates in an emergency move to counter the Coronavirus

-Anna Nicole Smith married for love.

Most people, at one time or another believed some or all of the above statements.  Which are misstatements?  Well for starters, the Feds lowered the interest rate due to another massive shortfall in the ‘repo’ world.  Briefly stated, the ‘repo’ world is where entities go to borrow short term loans (for days) using U.S. Bonds as collateral for the loans.  These are loans between the major banks for the most part.  When a borrower is unable to repay (repurchase the bonds) they are in default, (they do not have enough cash available).  Therefore, the Fed needed to pump cash, (create new fiat money) into the system quickly or risk a credit default or worse.  Coronavirus gave them cover.

The real shock that coronavirus has wrought on markets across the world coincides with a dangerous financial backdrop marked by spiraling global debt.  The ratio of global debt to GDP hit an all time high of over 322% in the third quarter of 2019, with debt reaching close to $253 Trillion dollars.  The implication, if the virus continues to spread, is any fragilities in the financial system have the potential to trigger a new debt crisis.  This is particularly important, because much of the debt build-up since the global financial crisis of 2007-2009 has been in the non-bank corporate sector where the current disruption in supply chains and reduced global growth imply lower real earnings and greater difficulty in servicing debt.  In effect, the coronavirus raises the extraordinary prospect of a credit crunch in a world of ultra-low and negative interest rates.

Much of this debt has financed mergers and acquisitions and stock buy-backs.  Executives have a powerful incentive to engage in buybacks despite very full valuations in the equity market because they boost earning per share NOT earnings.  By shrinking the company’s equity capital and thus inflating performance related pay.  Yet, this financial engineering is a recipe for systematically weakening corporate balance sheets-and in general, most are weak.

It is impossible to predict the trigger or timing of a financial crisis.  But the potentially unsustainable accumulation of public sector debt and of debt in the non-financial corporate sector highlights serious vulnerabilities.  The great experiment in ultra-loose monetary policy is intensely morally hazardous.  This is because unconventional Central Bank policies may simply set the stage for the next boom/bust cycle, fueled by ever declining credit standards and ever-expanding debt accumulation.  MCS/S Squared Capital has been discussing for years the state of overvalued equity markets.  Markets were also overvalued from 1922-1929 and they kept creeping higher, until they didn’t.  The correlation to the markets (the equity market overlay) is uncanny, as seen in the chart below- (via Gordon T. Long).

 We have been advocating for years on the overvalued equity markets, the futility of stock buybacks and the horrific state of the debt markets.  Investors have seen this backdrop before; in a milder version.  In 2007-2009, GM went bankrupt.  Equity and bondholders lost everything and new stock was issued, yet the company still operated.  We expect iconic companies to experience the same fate-think Tesla, Ford, GE and Macy’s and others.  Why?  Simply put-too much debt to service.  On the municipal bond front, in 2007-2009 several municipalities had defaults such as Stockton, CA and Birmingham, AL.  Today, with debt reaching even higher levels, some muni’s in states like California and Illinois will most likely default leaving pensions in shambles; even if the severity is not as bad in the equity markets shown above.  

Against such a backdrop, the conclusion has to be that if something can’t go on forever, then it will stop.  When coronavirus is gone, that will be when systemic trouble starts.   This is not to say that coronavirus will not add to the precarious situation.  Quarantining a large segment of any population reduces demand that trickles down, which will lower real earnings for many companies.  Much of the demand will not be replaced such as travel, and outside entertainment illustrated by the cancellation of major events like the South by Southwest Music Event in Austin and quite possibly the 2020 Olympics in Japan. SXSW was estimated to provide approximately $350M of economic impact to the local economy alone.

   Today, our technical charts illustrate a worst-case scenario of a 400-700 level on the S&P 500 (4000-7000 on the Dow), as this situation progresses, especially if things spiral and go to hell in a handbasket.  Markets are making history here, but we are in early days.  Central Banks will continue to attempt to ‘control’ markets’ as things spiral.   As shown on the chart, it took more than two years from the first large downturn to fully bottom out.  Let’s be clear-We are not saying this is will happen this time, only that the set-up is worse for markets today- higher debt, world markets and trade dependence more correlated, full fiat currency (in 1929 the U.S. was still on a Gold Standard), corporations weaker, huge Central Bank balance sheets, socialist backdrop of entitlements and ultra-low interest rates.  The market will continue to gyrate, leaving many to think buy and hold may work.  As the situation continues to unfold, we will update readers on new events that could change the course of the markets (for better or worse), as well as inform as to when trades are made.   Of note, the virus began in China, a country whose major index, the Shanghai Composite is down 50% from the high in 2007 and approximately 40% from 2016.  Chart of the Shanghai Composite from 2007 to present via Big Charts.com.  Many readers may not be aware that the second largest economy in the world, China, has been in a long-term bear market while the U.S. market was ticking new (QE, Buy-back) induced highs.

  They say when dealing with markets (companies, sectors, etc.) that the best fall last.  This is an attempt to merely inform investors of what is possible-not to educate or prophesize.  Please do not trade from any of our information.  It is merely informational and reflects our diligent research at this point in time, as well as our thesis and fact based research.  We use this information in our daily analysis of markets and are not aware of your personal holdings, risk tolerance or belief system and willingness to endure loss.  S Squared Capital trades capital with a philosophy and methodology using technical, fundamental and economic indicators.  A strategy such as S Squared never mirrors the S&P500 and is not intended too. 

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