2020 stock market crashes
The stock market keeps plummeting while Coronavirus continues to spread all over the United States.
Will the Fed come and buy the stock market?
I think there’s a huge possibility.
I will get into the details by explaining three relevant points in this equation: The severity of the Coronavirus, the importance of the stock market in our economy and what’s left for the Fed to act and save the day.
The reality of Coronavirus and the stock market
Our biggest mistake so far has been looking at the Covid-19's numbers as they are right now while ignoring what the numbers will be in the future.
In order to wrap up our heads around the severity of this situation, we need to focus on certain data points: R0 (the expected number of cases directly generated by one case), how many people will require hospital beds, and the number of beds we currently have.
In this chart we can see a comparison between the Coronavirus and the flu:
For every person having Coronavirus, four other people will be infected. With the Flu only 1,2 people were infected, per case.
If we analyze this further and go through the same infection cycle three times for Coronavirus, the result will be 21 people infected. Think of this in terms of weeks.
The growth of Coronavirus is exponential.
The second key metric is how many people will require a bed?
Assuming the exact same number of people who had the flu will now have the Coronavirus, it means there will be 20 million cases a year, of which 10% of them will need a bed.
If the flu infection required 200.000 beds, we will need 2 million for the Coronavirus.
Currently, there are 900,000 beds in the United States, but 68% of them are typically in use with people who have other healthcare needs, which leaves us with only 288,000 beds available for 2 million people who will need the bed.
This is the reason why the death rate if it’s low, won't matter because if the hospital system isn’t enough, the death rates will go through the roof.
It’s also essential to understand this won’t happen in three days nor three weeks, it can last for months, often the entire year going down during the Summer but coming back in the fall, and much worse during the fall than it would in the spring.
There’s also a common belief that if China is now doing alright because the infection has flattened out, it means we’re going to be okay too, but, there are other factors we need to understand.
1. China’s numbers are most likely not accurate, because if you take a look at the pollution or traffic reports, you’ll see their activity is still very low.
2. China took draconian measures, to say the least, to make sure their R0 of 4,08 went down to 1 or lower.
So, if we take into account all of this and Wayne Gretzky’s advice to skate where the puck is going to be rather than where it has been, we’d have to look at some of the risk factors exclusive to the United States no one’s talking about.
Risk factors we know of are related to elderly people and smokers because it’s a respiratory disease, but there’s also another factor that can become very serious because it can turn many cases into life-threatening cases, and that’s obesity.
As Joe Rogan affirmed in his podcast, 45% of the population over 45 years in this country are obese or severely obese.
The question is are we prepared for this in the United States? If so, what would this do to the economy?
The importance of the stock market in the U.S. economy
In our country, the stock market equals the economy, whether you like it or not, it’s the reality.
Economy = Stock Market
How? Let’s analyze this chart:
The chart shows the market cap as GDP, which crashed down in the early ’70s and was very cheap during the ’70s and ’80s.
However, in the ’90s there was an internet boom and the bubble took us all the way to 147% of GDP to then crash down in 2002.
It rose again in 2003 due to the housing market bubble and, again, it went crashing down in 2008.
Since then, with quantitative easing, and artificially low-interest rates we got back into an all times high reaching 158% GDP.
Today, the stock market has been coming down again, especially for the last couple of weeks because the market has tanked, nevertheless, we’re still at 138% GDP.
If it goes down as far as it did in 2007, to those levels, which I think it’s very possible, we will be having a 70% GDP.
In other words, the market cap, or how much money people have in the stock market, how much paper wealth they think they have, will go from 27 trillion dollars to 13,5 trillion dollars.
Think of the amount of purchasing power it’s lost by the stock market going down to 2007 levels, and this is assuming it won’t go down to 1981 levels, which would take us to 40% GDP.
On the other hand, there are 3,8 trillion dollars in the 401(k), and I’m only talking about the asset side of the equation because there’s another side which is far more important: The corporate bond market.
Stock prices crashing means the corporate bond market will most likely blow up.
If the corporate bond market does blow up, unemployment will go through the roof and affect spending dramatically, this, not mentioning the gig economy where a lot of people make ends meet by driving Lyft and Uber or maybe renting out their place on Airbnb.
Unfortunately, these companies might bleed out money because they’ll now go into the junk bond market where they use to pay a certain interest rate to find out they were doubled or tripled.
Most of these companies will go out of business, and people who were part of the gig economy will now have a big problem.
To have a better grasp of this think of Ray Dalio’s explanation of how the economy works.
I love how he explains it because he takes something extremely complex like the economy and simplifies it like this:
“Spending drives the economy. This is because one person’s spending is another person’s income. Every dollar you spend is someone else earns, and every dollar you earn, someone else spent, so when you spend more, someone else earns more.”
The bottom line is, if the stock market collapses, we will get into a doom vortex.
Lower asset prices mean higher unemployment rates and lower purchasing power, the lower the purchasing power, the more unemployment we’ll have, the more unemployment we’ll have, of course, the lower the purchasing power we’ll have.
This is huge because we’re talking about an economy where 70% of its GDP is consumer spending.
This is why I say the economy equals the stock market.
Will the Fed buy the stock market?
Before I answer the question, I need to give you some context.
With this whole situation, the Fed will have two tools: Interest rates and quantitative easing.
If the stock market goes into free fall it’s very probable the Fed will intervene and stop the carnage by making an unexpected rate cut of 50 basis points.
However, let's say the market will continue to go down by 700 points, and the Fed is already at 1%, which means they only have 100 basis points left before they get to zero bound.
So if interest rates aren’t a tool anymore, the only solution left would be quantitative easing, and here's how it works:
The Fed goes to all the primary dealers and the banks under their umbrellas to buy their treasury bills, and to do so, they will have to print funny money, as I call it, and put it into the bank's reserve accounts.
Getting the reserves into the financial economy to buy stocks requires a decision from the banks. Either they buy the shares themselves or they use the reserves to lend the money to hedge funds and other financial institutions that will take the new deposits to buy shares and take the market up.
The Fed obviously understands this problem just as I do, and they’re even talking about buying stocks as Eric Rosengren said.
My point is the Fed doesn’t have a magical light switch they can turn on and off directly impacting the stock market.
Anyway, there's also one more thing to add to the mix and that's government’s actions, meaning fiscal spending.
We’ve heard about it by the administration and even by Trump himself saying they’re going to handle it because they’ve projected 8,3 billion dollars of additional spending and a payroll tax cut up to one year.
Yet, I think they’re not being aware of the deficit and unemployment.
In order to explain what I mean by this, we would have to explore the additional problems we would have with the deficit if payroll taxes were to be eliminated.
To do so, let’s analyze this Federal Tax Revenue chart:
The payroll tax went around 5% to10% at most in the entire tax revenue pie in 1945, and it moved all the way to 30% of tax receipts to the modern-day.
So if payroll taxes were to be eliminated, our trillion-dollar deficit will explode over 2 trillion dollars.
Also, if we see the total tax receipts generated from an individual's income taxes, as a percentage, we can see it stays very consistent regardless of whether the top marginal rate is 90% like it was in the ’50s, or 25% like it was in the ’80s.
The biggest thing affecting income taxes and how much is paid is not the highest marginal rate but the direction of the stock market, the paying capacity depends on the economy.
Besides the deficit, there’s also unemployment, so the question is:
How is a payroll tax cut going to increase the spending of someone who doesn’t have a job or has a business that’s gone bankrupt because the stock market has crashed and the corporate bond market has blown up decimating the entire economy?
The takeaway of the government and the Fed is anything they do requires a third party for them to take action. They don’t have total control.
If you think they saved the day back in 2008 by dropping interest rates and doing quantitative easing, and they were bold in their approach with the fiscal spending tarp and bailouts, they won't be able to do it again.
The 2008 problem was significantly different from the one we’re having today.
The catalyst of the whole financial system imploding back then was because the asset side of the bank’s balance sheet had a lot of garbage: Mortgage-backed securities and oceanfront property in Arizona.
The Fed was able to paper over this problem by putting a band-aid and kicking the can further down the road by printing funny money, putting it into the reserve accounts of the banks and taking the garbage off of their balance sheets.
The damage to the real economy was people had less home equity, and they were angered by it, however, they kept on working outside of their houses, contrary to what we might see in the next couple of months in the United States.
People won’t be outside of their homes working, rather they’re going to be locking themselves at home wearing face masks and doing everything they can to avoid getting Coronavirus.
Today’s situation is a different economic animal, and if the Fed nor the government are prepared for this, no amount of quantitative easing, interest rate drops, money printing or government spending will handle this type of problem.
This will put the Fed in a position where instead of being the lender of the resort, they’ll be the buyer of the last resort.
Hence, I’m very confident that if we get into China or Italy’s type of situation, we’re going to see the Fed come and buy the stock market.
For more articles like these and to go further into how the corporate bond market works, take a look at my previous blog.
See you on the next one!