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Zombies and betting on bankrupt companies: where is the stock market heading after the COVID-19 shock?

Stock market after covid-19

Over the last weeks I have been analyzing a lot of expert opinions about the current state of the markets.

I tried to keep an open mind and listen without prejudice to a wide variety of outlooks – from very pessimistic to very optimistic ones.

Today I would like to share with you my thoughts on that.

“Making predictions is hard, especially about the future…” (Yogi Berra)

When it comes to investing, we are notoriously bad at predicting the future. Even the best experts in the world can fail badly at predicting the short- and medium-term movements of the markets. Case in point, Warren Buffet seems to have sold his entire holding of airlines stocks at the worst possible moment, just before they rallied almost 100%.

So today, like always, I will not try to give you my predictions, but I will talk about the probabilities.

In the courses I always talk about the positive long-term (10y+) outlook for the stock market. This is based on the understanding that historically businesses (stocks) produced the best possible long-term returns compared to other asset categories.

But what about the short- or medium-term outlook?

Let’s take a look at the two different views on that.

#1: The case for stock market to go up in the short- to medium-term

The stock market is significantly overvalued at the time I’m writing this (10th of June). The total market cap relative to the US Gross National Product (the Warren Buffett indicator) currently sits at a whopping 150%+. That is higher than during the dot com bubble.

But we can still find a lot of reasons why it can go much higher.

A) FED balance sheet is getting bigger and bigger – it’s going to infinity and beyond.

Check this out: The FED had assets worth $870 billion on its books in the week ended on August 1, 2007, just before the start of the financial crisis, and the same stood at $2.23 trillion at the end of 2009.

In March 2020, it was $4.75 trillion).

In June 2020 it’s $7.21 trillion!

Translation? The US central bank (FED) is greatly increasing the amount of bonds and other assets it owns in an effort to keep markets and the economy afloat during the crisis.

Unlike businesses, the Fed can expand its balance sheet by printing as many dollars as it wants. It’s like creating money from thin air. Just add some zeros in the computer.

The FED is simply saying: we will do anything to save the market.

That is why everybody from professionals to gamblers is buying, because FED is manipulating the market and artificially keeping it high. Never fight the fed, right?

B) Capital flows to the (mostly US) stock market from all over the world.

If you want to invest your money there are not a lot of alternatives to the US stock market. The FED is buying bonds, and this keeps their yield low (higher bond prices mean lower yields). So, if you have your money in bonds or in the bank you will get almost zero return.

Low rates punish people who save money and they are motivating them to invest in the stock market.

If you want to have higher yields, you are basically forced to go into the stock market.

#2 The case for stock market to go down in the short- to medium-term

A) The economy is in a really bad state

I probably don’t need to tell you that 🙂

Unemployment stats are getting better, but they are still record high.

A record number of companies are being downgraded in the last months. S&P Global has identified almost 1,300 potential credit downgrades around the world in its latest credit update. This is higher than the previous record set in April 2009, during the financial crisis.

Corporate downgrades

These companies are likely to have problems servicing their debt and a lot of them will go out of business.

But… the stock market is still going up. The stock market is currently priced not only as if there was a full recovery, but as if the situation is better than it was at the start of this year.

B) Less share buybacks

From 2010 on, the corporations have been buying back their shares in previously unseen quantities, thus keeping the prices of stocks going up constantly.

The biggest reason for the bull market was share buybacks. When corporations buy back their shares, there are less shares in circulation and their prices go up. Supply and demand.

Of course, there is (almost) nothing wrong with that. Share buybacks are a way to reward the shareholders by increasing the price of shares. But the downside is that they don’t add to the productive capabilities of a company. This is a purely a financial investment and not an investment in the research and development.

And on top of that many share buybacks happen with the borrowed money. Companies are getting a ton of cheap credit, but this money is not being invested in the real world, it is just boosting the stock prices.

But in the next years the consumer demand will not grow as fast as in the past and corporations will need to sell more shares to finance their operations. Plus, there will be less share buybacks because the corporate profits are on a decline and companies need to shore up their financial positions. And don’t let me forget … corporate taxes will go up because governments will need more money to cover all the debt they are amassing.

In be Q1 the trend of increasing corporate buybacks has already started to turn…

Corporate buybacks

This will mean more shares in the circulation. When you have more shares outstanding, their prices go down. Again, supply and demand.

The biggest problem today I think is, that the cheap credit and the FED financial stimulus is not being invested in the real world but it’s chasing financial assets.

This money is not engaged in increased production or in building infrastructure. It doesn’t end up in people’s pockets. It’s just engaged in financial speculation.

This of course can’t go on forever.

C) Emotional sentiment on the market is greed

Stock market has been rising so fast, that the average investor (“dumb money” as the professionals call them) has become increasingly optimistic about it. This is creating all sorts of bubbles in the market.

Citigroup’s panic/euphoria model is showing sentiment at the most euphoric since dot-com bubble era.

Check out the trading app Robinhood for example. It’s creating a new daytrading culture where bored people gamble with their stimulus money. A couple of months ago it had 10 million users, but because of the COVID19 this number went up to 13 million by May 2020.

And their users are making all sorts of crazy bets. For example, investing in Hertz stock. On the chart below (source: you see that the bankrupt company shares went down from $20 to almost $0 when Hertz filed for bankruptcy.

But look at the last weeks data. Number of Robinhood users holding Hertz stock went up to 160,000 and the stock price went to $6.

Robinhood speculation

Let me just remind you that shares of bankrupt companies are not worth very much! They almost always end up being worth zero at the end (even though they can still trade for years).

Now, if this is not gambling, tell me what it is…

Here is a quote by Brent Donnelly that encompasses this perfectly:

This rally in all things Robinhood, such as airlines, hospitality and bankrupt companies is part of a retail bubble spurred by free money, free trading and bored gamblers. Watch for the inevitable burst but don’t get married to either side.

My guidelines

As you can see, we have a lot of reasons why the stock market can go up or down in the short to medium run. So what should we do?

  1. Don’t speculate! Never, never, never speculate and trade the markets trying to make a quick profit. Most speculators lose their money sooner or later.
  2. Be ready for increased volatility of the stock market in the next years. There will be times when we will have panic selling on the market and there will be periods of euphoria.
  3. Use cost averaging method of investing to take advantage of the increased volatility.

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