Relapse

The coronavirus is proving to be a tenacious adversary for our health and society. The sense of victory felt due to the flattening of the infection curves around the world and the optimism accompanying the efforts to reopen economies have been deflated by the resurgence of the virus. Not only have virus cases increased, in many areas they have hit new record highs. In the U.S., California, Arizona, and Texas virus cases are jumping as are hospitalizations.

Expectations that the U.S. outbreak would follow the path of Italy, Spain, and Germany have proven too optimistic. The U.S. curve not only hasn’t declined but is turning higher. Scott Gottlieb, former FDA Commissioner, put the question facing us all succinctly: “Can we keep this from getting out of control? This is a virus that wants to infect a very large part of the population.”

These trends are mirrored globally also, with Brazil recording over 1 million infections and showing no sign of slowing.  India is the fourth worst-hit nation, with cumulative virus cases over 320,000.  China, which had offered hope of some return to normality after it aggressively quarantined entire cities in order to get control of the pandemic, is also showing signs of resurgence.  It put 400,000 residents of a northern county under lockdown over the weekend after at least a dozen coronavirus cases associated with the Beijing outbreak were reported there.  The outbreak was traced back to Beijing’s Xinfadi wholesale food market, which houses warehouses and trading halls in an area equal to almost 160 soccer fields.

Far from being able to declare that the worst is over, we are facing what may be worse to come.  Relapse not only threatens human health but also the fragile business environment the virus has created.

The American response to the coronavirus was a patchwork of state-led policies with no cohesive mandates from the federal government.  States determined their own quarantine priorities, and their schedules for reopening economies.  The U.S. today is more deeply divided than it has been in decades.  Divisions fall along political, racial, economic, and generational lines.  In today’s divided America, attempts to practice good hygiene and concern for social well-being have become politicized and morphed from science-based recommendations to perceived limits on personal liberty.  Only in this extraordinary environment could masks become a political statement.

After shutdowns put the U.S. into an economic coma in March and April, states will be reluctant to reimpose lockdowns.  Yet it is clear that rising virus cases will come with serious economic ramifications.  The hoped-for return to normalcy will be deferred even longer.  Consumers now know the protocol for protecting themselves, and will remain hesitant to venture far from home or into crowded businesses or gatherings.  Recovery for businesses will be postponed.  While formal shutdowns are now unlikely, human behavior can recreate the effects of them without a formal announcement.

Wall Street has been on an upward trajectory since late March, driven by hopes for recovery and massive increases in liquidity created by the world’s central banks.  But Wall Street’s recovery story is losing support as coronavirus cases multiply.  Investors have taken heart from numerous indicators that have spiked up, stoking hopes of a V-shaped recovery.  Retail sales, for example, jumped a record 17% from April to May, eliciting cheers from pundits and manic share buying from investors.  But this enthusiasm overlooked retail sales decline of minus 8.3% (March) and minus 14.7% (April).  The same applies to jumps in durable goods and new home sales.  The current rises are naïve extrapolations of a welcome change of the downward trends of the spring, but most likely represent only short-term pent up demand by a populace that has been homebound for months.  Of course the data will look positive, especially when measured in percentage changes from the depressed lockdown months.  A more realistic perspective can be gained by measuring the change from a year ago.  On that basis, economic trends are still negative.  The same retail sales that brought solace to investors is down 6.1% from a year ago, and durable goods orders (up nearly16% April to May) are down 17.9% year over year.  Just as with the virus itself, it is important not to lose our perspective on current rosy economic reports.

The most important factor to consider is labor and employment itself, as that is where the impetus for sustained spending and growth will come from.  While the Fed can create an environment conducive to borrowing, they cannot increase incomes or create jobs.  That will have to happen the old-fashioned way, by companies selling more widgets and hiring people to make, sell, and deliver them.  With federal support programs set to expire between July and September, employment trends should be at the top of everyone’s economic health checklist.  On that score, the signs are improving over a few months ago, but are far from conveying a robust economy.  Initial unemployment claims have drifted down from the dark days of April, but are still clocking in at over 1.5 million new claims per week.  “Continuing” unemployment claims offer a broader perspective, now that some workers are being recalled to their jobs, but it, too, provides a sobering view of the challenge ahead.  Continuing claims now tally just under 20 million people, a level that has dwarfed any reading over the last 60 years.  We believe that “trickle up” economics will determine the pace of any recovery, because household income, spending and confidence is key to overcoming the coronavirus recession.  Based on the relapse in virus cases, however, we should expect consumers to hunker down again and cause retrenchments in recently positive economic indicators.

We believe the stage is set for a relapse on Wall Street also.  The stunning rally from the March lows has been underscored by the new mantra, “the Fed has our back.”  In other words, investors can count on massive injections of liquidity (money printing) to keep asset prices high.  It seems to be a case of heads-we-win, tails-we-win for Wall Street.  If the virus keeps recessionary conditions in place, investors can count on central banks globally flooding the financial system with money, with salutary effects on stock prices.  If recovery takes hold, stocks should benefit from increases in income, spending, capital expenditures and earnings growth.  But is it all as simple as this Pavlovian stimulus-response behavior implies?

Several clouds seem about to rain on Wall Street’s parade.  The first, and one of the most important, is the sell signal given by the NYSE advance/decline (a/d) line.  This indicator measures the cumulative difference in the number of stocks rising in price versus falling in price each day.  The net difference is added (or subtracted) from the ongoing total, and creates a line that trends up or down.  Plotted as a point-and-figure chart, buy and sell signals are easily identified.  The a/d line has been quite timely in identifying the changes in the broad trend of stock prices, and signal changes should be taken seriously.  The a/d line gave a sell for the week ending June 26, and implies that the recent relapse in virus cases is about to hit the sanguine assumptions supporting stocks.  The a/d line sell implies the prevailing trend in the market is now down.

Second, bullish sentiment among advisors and newsletters has now reached 55%, according to Investors Intelligence.  This level matches the highly optimistic levels seen in January 2020, and implies that investors have committed much of their cash to stocks.  By contrast, the percentage of “bearish” advisors has fallen to 18.4%, a level consistent with recent market tops.  It is easy to see why investors have become bullish again.  The almost relentless rise in stocks, signs of economic stabilization, and a “fear of missing out” have all contributed to this ebullient mood.  But sentiment is a contrarian indicator, so high levels of bullishness actually imply risk is high, not low.

Finally, the rate of change in the Fed’s “balance sheet” has actually turned negative.  This has been the primary driver of stock prices since 2009, and explains much of the coronavirus rally.  While it is too early to tell whether this is part of a longer-term reduction in the Fed’s money printing program (“quantitative easing,” or QE), it’s well known that stock trends are highly correlated to the increases and decreases in the level of the Fed’s balance sheet.  At the very least, a flattening in the rate of increase tells us the best of times for the liquidity party may be behind us.  Without the benefit of massive liquidity injections, and facing the prospects of consumer and business retrenchment due to the virus relapse, stocks may struggle to make headway from their current levels.  The message from the NYSE a/d line and overly bullish sentiment lend credence to this cautious outlook.

According to the financial journalist and historian James Grant, “progress is cumulative in science and engineering but cyclical in finance.”  As such, we have no doubt that our cumulative knowledge in medicine, combined with things we are learning every day about coronavirus, will ultimately lead to a vaccine for it.  But financial markets learn their lessons over and over again.  The difficulty in quashing coronavirus reminds investors that Fed policies cannot replace the basic tenets needed for a healthy financial system—jobs, income, the ability to repay debt, and confidence about the future.  The relapse of the virus is going to test those foundations to their utmost in the summer ahead.

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