The Dow Jones Industrial Average continues its week long rally amidst the coronavirus outbreak, bringing the stock market up some 20% from the most drastic crash since 1973. At first glance, this seems counter-intuitive.
Lock down measures are more stringent than ever, with people being enforced to stay at home. Throughout this period, teens spending falls to the lowest in 9 years, and consumer spending has dropped drastically too. Businesses are struggling to stay afloat, burdened by high levels of debt and dwindling revenue.
Jobless claims rose by 6.6 million in the United States alone to a total of 16+ million unemployed personnel, a 10% loss in employment. Sure, we aren't hitting the 30% unemployment rates of The Great Depression yet, but that's a lot of unemployment - meaning that business are firing people left and right to reduce operating costs. By all means, this paints a very gory picture of the economic scene, but the stock market is rallying!
What gives? Is this a bear trap, or is this a sign that recovery is on the way? Let's rationalize the situation and find out.
Understanding the coronavirus recession
To begin, we have to first understand recessions. You can read this article to know more about how recessions happen, as well as more detail about The Great Depression and The Great Recession, two of the biggest recessions in modern history.
Generally, recessions occur due to two main factors:
- An overvalued, overbought stock market where prices are too high for their intrinsic value
- A decrease in spending and an increase in saving, making the high valuations unsustainable (due to lowered revenues)
These two factors combine to damage investors' confidence, which causes prices to plunge. This further reduces spending as more people hoard money in uncertain times, which repeats the vicious cycle.
Correspondingly, we were at the peak of the longest bull market in history, causing the first point to be true. Stocks were overpriced and overvalued. Secondly, with the coronavirus outbreak shutting down businesses and non essential services, as well as measures to implement social distancing, spending is also at all time lows.
By all counts, we should be in recession territory! And we are - stock markets crashed heavily in one of the biggest crashes since 1973.
Can you spot the two major recessions in 1973 and 2009? Our current dip caused a dip larger than the dip in the last two recessions! This raises a question - is the current recession going to be worse than the previous two major ones?
The uniqueness of the coronavirus recession
The current recession brought about by the coronavirus is what I would term a "false" recession. In normal recessions, something broke in the economy - spending levels could not keep up with over-inflated prices, leading to mass selling of stock and bearish sentiments. However, in this case, the recession was caused by the spreading of the coronavirus, forcing businesses to shutdown and spending to stop.
Why is this key? This means that the stock market was still ready to grow. This means that if a vaccine was found, or the coronavirus was successfully curbed so that everyone could go out to work and spend again, the economy would rebound quickly. This is because the economy still had potential for growth before the coronavirus hit - meaning that spending was stable and even increasing. Remove the virus, and spending will continue, causing rapid recovery.
Of course, this hinges on the fact that when we say the "virus is gone", we are assuming that consumers will be willing to go out and spend again. This must come in the form of a vaccine or a guaranteed solution. If there is the possibly of contracting the virus and dying - consumers will still be afraid to spend and businesses will be afraid to open, making recovery slow.
On the other side of the coin, this phenomenon also means that the current drop will be hard and heavy. Since hard measures are put into place to stop consumers from going out, spending is hit immediately, and hit hard. Compared to previous recessions where spending could continue even during the recession (by people going out and businesses functioning), everything has come to a halt during this coronavirus outbreak. This naturally worsens the situation.
As to whether the first scenario of an expedited recovery will occur or the second where a prolonged battle with the coronavirus happens, that's still up in the air at the moment.
If you have read my article about the coronavirus recession, you will know that I advocate looking at the graph of coronavirus cases to determine optimism in the situation. As of writing this article (10 Apr, 2020), the growth of cases in the US still looks pretty exponential to me. That does not bode well for economic recovery, and I'm learning towards a pessimistic standpoint unless a vaccine is discovered.
Why is the stock market rallying?
After all that grim news up above, some might be surprised that the stock market is actually rallying this week. Well, you are not alone in being surprised.
So why is this happening? The simplest, most straight forward answer would be to look at the US's federal reserve. The federal reserve is a central banking system in the US that monitors the economy and ensures its functioning. In fact, it was set up to serve as a central source of funding to stimulate the economy during a financial crisis. And that's exactly what it has been doing.
Just two weeks back, when the federal reserve announced 2 trillion USD in funding to support businesses and unemployed workers, stock markets reacted sharply and rose drastically for almost a week. It may not be quite clear how large a sum 2 trillion is. The US's annual GDP is around 20 trillion. 2 trillion is around 10% of that - meaning that it can fully fund the entirety of the US for around 1.2 months! OK, it may not be that realistic, but you can kind of get the scale behind this move.
And yet, just barely a week after that, the markets crashed heavily again. What gives? Well, it turns out that although an announcement lifts investors spirits for a while, businesses and the people were not getting the money quick enough. That's to be expected - 2 trillion is an insane sum to distribute out. While large companies claiming bailouts will be the first to get their hands on part of that sum, as an individual you can expect to not see your money for a long time.
It also turns out that giving out free money is not sustainable in the long run. Handing out money is not consumer spending. Handing out money does not mean that businesses can continue to run. Everything is shut down during the coronavirus outbreak. This means that fixed costs are still happening - and businesses are still sacking people to make up for the reduction in revenue. In other words, even 2 trillion isn't enough to keep the economy afloat if people aren't spending and businesses aren't growing.
Now, you might have thought at this point that it's about time the markets crashed all the way down. But that wasn't the case. The federal reserve still had more tricks up their sleeve.
A never ending money printer
One of the benefits about being the federal bank is that well, you can print money. A lot of money. Nowadays, it isn't even printing physical notes, but digital balances. The federal reserve just have to add a bunch of zeros in banks balance sheets and call it a loan, and viola, new money.
In recent news, jobless claims rose by 6.6 million in the US alone to a total of 16+ million unemployed personnel, a 10% loss in employment. And yet, the market barely reacted to such terrible news.
It turned out that at almost exactly the same moment that this statistic was released, a larger, more flashy announcement came out - the federal reserve was supplying 2.3 trillion more in loans to support local businesses and governments. Remember, that's 1.2 months of the entire US economy worth of money!
Following the announcement, who cares about jobless claims? Who cares if people aren't spending any money? There's around 2 trillion or more being pumped into the economy. It would be strange if the economy didn't surge after such a move!
In total, the federal reserve has "printed" almost 6.6 trillion worth of USD. Some of these loans even have interest rates deferred for a year, making them very attractive. A large portion of this sum has been used to bailout companies teetering on the brink of bankruptcy - companies which had overspent their budget for years on share buybacks and took on huge debt to chase profits while dodging taxes.
Is this fair? Well, certainly not. There should be two large questions looming on everyone's mind right now:
- How can the federal reserve just keep printing money? Won't this cause insane inflation?
- What are the consequences of this infinite money printer?
The role of quantitative easing
Let's deal with these questions in order. Our instinctive reaction when we hear infinite money printing is that it can't possibly happen. Indeed, it is unsustainable to keep printing money, because if there's too much money, the value of each dollar falls, causing hyper inflation. One only needs to look at the Zimbabwean dollar to find out what happens next - the completely loss of value in the currency.
But what exactly is the concept of printing money? In actual fact, such a move is not really printing money, but termed as quantitative easing. Simply put, quantitative easing occurs when the central bank (the federal reserve) "prints" money to purchase long term securities like bonds or loans, usually at low or zero interest rates. This has the effect of basically lending out money for almost nothing to banks, who in turn lend out this money to businesses and individuals at a lower interest rate as well.
In essence, this is just the transferring of money from the central bank to banks to businesses. This results in the lowering of interest rates as a whole, increasing liquidity and encouraging confidence in the economy in a bid to stimulate spending and growth.
The cons of this move is naturally the risk of hyperinflation and the subsequent devaluation of the currency. Therefore, the main aim of quantitative easing is to ensure that businesses have enough money to recover and stimulate the economy enough such that the economy's recovery can cover the inflation, loan paybacks and other risks of such a move.
One thing that the USD has going for it is that when times get hard, people start hoarding the US dollar (and gold, of course) instead of any other currency. This is because banks and governments worldwide base the USD as the global currency, and thus deem it as a reserve when things get bad. This means that in crisis like these, the USD actually appreciates in value as people give it more value compared to other currencies. That kind of counteracts the devaluation of the currency caused by hyperinflation due to quantitative easing. In fact, in recent times, we see the USD steadily appreciating in value!
Therefore, these factors combine to place the US federal reserve in sort of a unique position, where they can keep printing money to stimulate the economy at little risk of economic ruin due to hyperinflation. Of course, this is a non-zero risk, and therefore still not sustainable in the long run. If economic spending doesn't improve, businesses will happily take up all the low interest loans and contribute nothing back to the economy. Then, we will truly see economic ruin. It all depends on how long this coronavirus lock down will last.
The consequences of quantitative easing
For businesses, quantitative easing can only be a good thing. It's basically free money from the government with low or negligible interest rates that you might not even have to pay back in the short term. Who doesn't like free money? That kind of explains why the market is rallying so heavily right now.
But what are the other consequences of an infinite money printer? We have learnt that this is unsustainable in the long run if we do not want to risk hyperinflation. The main way to recover from a recession is to restore consumers' confidence and to restore economic spending. The easiest and fastest way to do this is to create a coronavirus vaccine... which we don't have yet.
So sure, this may be a temporary stopgap. But what about the 16+ million unemployed people in the US? Those people don't have jobs, but they have obligations to pay. Do they get financial relief? Well, they were promised financial relief, but most haven't got it yet. Those people are not going to be splurging on things any time soon. Everyone's only out to buy necessities these days. Without excess spending, the economy cannot grow.
The consequences of quantitative easing is that, yes, in the short term, businesses will appear to thrive. In the long term, however, if economic spending does not pick up, businesses will continue to suffer, and people will start being unable to sustain their debts and liabilities. That's when a true recession will start to happen, not one caused by the coronavirus lock down.
Is this a bear trap?
So is the current stock market rally a bear trap? After the whole article above, you might be thinking that it might be. Now, I'm not going to put my opinion here to sway your decision - but let me provide two sides of the argument for you to decide on your own.
Scenario 1: Bear trap!
The first scenario is yes, the market hasn't experienced the worst yet. For some, quantitative easing by the federal reserve may feel like a fake prop up of the economy - and you might be right, it is. This artificially inflated loans to businesses can stimulate the economy in the short term, but whether the economy recovers is dependent on businesses and consumers resuming normal operations.
If that recovery doesn't come soon, then quantitative easing is going to hurt a lot more in the future since the economy is now inflated with new loans.
Scenario 2: Recovery!
The second scenario is more positive. While everything all sounds like doom and gloom, central banks around the world are ready to do what it takes to stimulate the economy throughout this trying period.
In fact, the federal reserve is pulling all its levers to stimulate the economy, coming out with many new loans to support all kinds of market loans in order to restore investors confidence. To this end, they are willing to continue with more and more quantitative easing. At this point, it has become a race to see if the infinite money printer will destroy the economy first, or if recovery will come in time to save it.
Nobody can predict the market
If you saw this sub-heading and felt cheated, I'm sorry. But it's true. I certainly can't give you a definite answer as to what will happen - the market's too volatile for that and I don't have insider news either. What I can tell you is this.
If you felt like you have missed the dip a few weeks back and are regretting it now, don't. Nobody can predict the market. The only "less-risk" way to navigate market volatility in this tumultuous period is to stay true to your investing tenets. In essence, buy in when you think it's worth your value, and don't sell if you think it's not worth selling. All other missed out gains are just that - hindsight and not worth you agonizing over. Life moves on.
Times like this are why we invest. That said, don't view investing as a get rich quick scheme. Even if you managed to buy in a dip, you would still have to wait for the stock to appreciate back in value. It was always about watching paint dry. No matter when you buy in - you need time to get your returns. Don't let short term losses hurt your long term worldview.
This coronavirus recession is really a special kind of recession, in that its situation is unique and nobody really knows where it can go from here. Will the infinite money printer win? Or will the doom and gloom and lock downs ruin the economy? It's almost like a game at this point... except it's not.
There are real people out there fighting and struggling for survival as their income is cut off. There are people dying out there to the virus, and front line staff working hard to keep people alive. As investors watching the economy, it all seems like numbers on the screen, but it really isn't. Life is not a game.
Think of the people around you, and be responsible where you can. Stay safe, and stay home. As much as we investors want the markets to fall to get more gains, I personally cannot wait for the coronavirus to be over, so that we can live again.
If you enjoyed, do subscribe to our weekly newsletter below to get a roundup of our latest posts and other goodies. No spam, promise! You can also follow us on Facebook, Twitter or Instagram for the latest updates.