To quote the great Richard Dawson, “Survey says ….?” Not to V! To also quote about a million other people from time to time: “Don’t kill the messenger.”
The recent rise in the stock market is completely divorced from economic reality. If you are running a charter school, or any other business for that matter, you need to plan for a downturn larger than 2008/2009. Having adequate access to liquidity and working capital is likely to be very important to your organization’s survival, because a decrease in liquidity can morph into a decrease in solvency.
Bob Farrell’s 7th (out of ten) rule of investing: “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.” On a market cap weighted basis, 22% of the S&P 500 is represented by five FAANG stocks, who have rallied significantly since the March 23 low because, in part, they are poised to benefit from a post-crisis stay-at-home economy. According to market economist Dave Rosenberg, corporate profits for the entire business sector have not increased in dollar terms since 2012. Over the past five years, pre-tax dollar profits have actually declined at over a 1% annual rate (before the impact of the 2017 tax cut). In fact, there were many signs that the economy was starting to weaken prior to Covid-19.
So, why was the stock market on such a roll until February? Again, according to Dave Rosenberg, corporate stock buybacks account for 1,000 points of the S&P 500’s 3,300 point peak. There is about $10 trillion in corporate debt outstanding today, up from $6 trillion a decade ago (40% of the then GDP). This $10 trillion includes all sorts of liabilities of borrowed funds, and in itself represents a record 50% of GDP, and that is before the contraction in GDP resulting from the lockdown. This $4 trillion increase in corporate debt corresponds nicely with the $4.3 trillion that The Harvard Business Review notes has been spent on stock buybacks by the 465 companies consistently listed in the S&P 500 between 2009 and 2018. So, all this talk of EPS multiple expansion has been a false narrative. Because the Fed has failed to normalize interest rates, even being “shouted down” by the stock market in late 2018 when it tried to increase rates, this has given companies every incentive to conduct the biggest debt-for-equity swap in the history of history. EPS of the S&P grew because there were simply fewer shares outstanding, not because of increased earnings. From an economic standpoint, the S&P 500’s real peak, based solely on economic performance, is really more like 2,300 instead of 3,300. As of May 15, the S&P still stood at 2,863. There is also the Fibonacci retracement theory which, from the March lows, would put the stock market right back about where it is before heading back down to re-test the March lows. (See Bob Farrell’s Rule no. 8 below).
OK, fine, you say. But then, why has the market rallied significantly since the March 23 low, now being something like 12-15% below the 3,300 peak, if the economy isn’t likely to experience a “V” shaped recovery. I can’t say for sure, but I believe two things are having a significant impact. Number 1, there is a huge institutional bias from the market infrastructure for markets to go up. Almost every commentator you read or see on TV has an incentive to talk up the market. I would bet you dinner that somewhere in the bowels of CNBC’s files there is research that says viewership is higher when the market goes up. Number 2, people have bought into the narrative that the Fed can save everything, giving no thought to two important concepts.
What we are experiencing is the bursting of a debt bubble, like in 2008 but on a massively larger scale, and the “hair of the dog” (i.e. more debt) palliative the Fed is employing has only helped the stock market, not the economy. Why else could it have not increased interest rates in the decade since the last crisis? Because the economy was too weak to stand on its own. But, the stock market beat the Fed back into submission when it tried to take leverage out of the system. Its balance sheet grew from far less than $1 trillion to $4.5 trillion due to the 2008/2009 Great Recession. Its response to this crisis will balloon its balance sheet to well over $10 trillion. When you see the Fed capitulate when the stock market throws a hissy fit like in late 2018, and then you see the Fed agree to buy debt of over-levered corporations who are less than investment grade, you can be forgiven if you form the view the Fed is here for the market, not the economy. Keeping “zombie companies” afloat isn’t going to help the economy grow after this crisis.
Another thing related to the Fed is that its policies could have decreasing marginal effectiveness given where we have started. Rates were already near zero, and when its balance sheet increases from less than $1 trillion to $4.5 trillion, and then onto well over $10 trillion, these policies are likely to have less punch.
And what about the economy? The recent retail sales data shows a decrease of 16.4% from the same time in April, which had plunged 10% from the previous time in March. GDP contracted 4.8% in the first quarter. The response to the pandemic really didn’t begin until March, the third of three months in the quarter. The Great Recession of 2008/2009 only saw GDP contract 3.4% and over a much longer period of time. The forecast for the global economy in 2020 is a 4% contraction: for some perspective, the global contraction during the Great Recession was 0.1%. As for the stock market, in the Great Recession it ultimately went down 60%, far lower than it has in 2020. See Bob Farrell’s eighth rule of investing: Bear markets have three stages: sharp down, reflexive rebound, and a drawn-out fundamental downtrend. (https://school.stockcharts.com/doku.php?id=overview:bob_farrell_10_rules). On top of the economic data, this is another reason not to believe the stock market regarding the shape of the recovery. We are only in the reflexive rebound stage.
Consumers represent 70% of the US economy. Consumer Confidence fell from 101 in February to 89.1 in March, to 71.8 in April. The April result represents a nine-year low. What this means is that the expectations of 70% of the economy has dipped 30% over three months. Another fact: fewer than 50% of Americans have enough savings to cover even two months of expenses. If you have no funds in the bank, and your view of the economy is dour, the likelihood that you are going to roar back to spending at pre-crisis levels is low. Most likely, your savings rate is going to increase, which will act to suppress the recovery.
And then there are the jobs. Most of you are aware that 36.5 million have lost their jobs since the lockdown began, and those most hurt have been the lower wage earners in the hospitality and similar service industries. It is the lower wage earners that spend their paychecks, facilitating higher demand, not the higher earners. The highest weekly unemployment claim figure in the Great Recession was 665K, about one tenth of the high from the week of April 4. There are reams and reams of data which tell us that it will take years to get back to levels of economic activity before the crisis in a wide range of industries: air travel, commercial real estate, the oil patch, and many others.
Many of you are already hearing from your State budget offices about likely levels of funding cuts next year. Many of you have outstanding debt which contain covenants related to days cash on hand and lease payment/debt service coverage requirements. Even if your state is not (yet) forecasting cuts, you can expect bigger ones for fiscal 2022, and you may want to plan ahead. If your organization is less than 500 employees, strongly consider applying for the second round of the PPP. If your organization does not have access to a working-capital line of credit, you should look very hard into getting such access, or to the ability to factor receivables if deferrals return (which they are likely to do in some states). Congress is not close to passing legislation that will assist State and local governments, so there won’t be anything trickling down to you anytime soon. But, maybe that will happen.
Nonetheless, its going to be rough. But the charter sector can do it. We have already seen how charters have continued to teach the stay-at-home students while many school districts have punted. Save cash, arrange access to working capital, and this, too, shall pass. But, not for a while, so take care and plan ahead.