Technically, the USA is already in a recession. Will the market crash again and if so how should you prepare?

The path ahead is both highly uncertain and subject to significant downside risks“.

Jerome Powell, Federal Reserve Chair

The coronavirus has created global crisis of unprecedented nature: global supply chains are disrupted, consumer spending is drying up due to lockdowns and social distancing measures, small and medium enterprises are going out of business, central banks are lowering interest rates to almost zero, corporations are taking on massive debt to raise liquidity, unemployment is rising rapidly, governments are printing trillions to stimulate the economy, and people live in fear of being infected.

Evidently, there is a clear disconnect between the stock market and the real economy: While talks of a recession intensify, the S&P 500 had its best month since 1987 and the Nasdaq Composite is higher than it was at the start of 2020.

However, the post-bailout euphoria is dying down and many investors fear that the flood of poor economic data will cause a second stock market crash.

Let’s be honest: nobody knows what will happen. However, we should remain prudent and prepare ourselves for a possible second massive selloff if the economic data doesn’t get better in the coming weeks.

Why is a second sell off possible and how should you prepare?

1 – The real economy is in crisis and the Fed can’t prevent a recession

Job losses and contracted business

Yesterday, the US Department of Labor revealed that initial jobless claims for the week ending May 9th was 2.981 million. Over the past 7 weeks, the total number of job losses exceeds 36M, which is more than 1/5 American workers.

Lower income households have been the hardest hit. A survey led by the US Federal Reserve shows that 40% of households making less than $40K per year have lost a job.

Businesses are not going back to pre-crisis levels just yet. High unemployment is driving down consumer spending, social distancing and political measures are restricting business activity and lifestyle habits may change dramatically.

What about the bailouts?

Last month, the US Treasury and the Fed unveiled massive bailout plans totalling several trillion dollars. Initially, everyone thought this would send the economy back into overdrive. While the stock market has recouped a significant portion of its losses, the bailouts are not stimulating the real economy.

How can a $6 trillion stimulus package not revive the economy?

First, the bailout money for small business was short-term or contingent. Very quickly, it became clear that the half-trillion dollar bailout for small businesses was wholly insufficient. The money was allocated within days and only a select few companies received funds. Those who did were imposed conditions: the majority had to be spent on utilities, mortgage payments and wages for workers; and loan forgiveness depended on the company rehiring their entire workforce once the economy reopened. Given the harsh economic climate, rehiring all staff is a pipe dream and these businesses will be stuck with million-dollar loans they will have to pay back, in a context of low consumer spending.

Second, the expanded unemployment insurance program encouraged massive layoffs. The generous benefits provided encouraged both businesses to lay off employees and workers to file for claims due to the extra $600/week federal payment added to state unemployment payments. This accelerated the rise in unemployment since most people thought the crisis would not last; everyone expected to receive the generous benefits for a few weeks then return to work once the coronavirus was defeated. This scenario is no longer viable and assistance runs out in July. Panic is creeping in.

Lastly, the Fed’s intervention in the capital markets did not benefit the real economy. In February and March, the Fed shored up capital market liquidity in an effort to rescue money market funds, and short-term lending markets for corporations and financial institutions. The issue is that these measures rarely come with strings attached and these institutions keep the money for themselves rather than inject it into the real economy. As in 2008, when the banks received hundreds of billions of bailout money, they are using these funds for their own purposes, such as buying up equities and corporate bonds. This is not helping small businesses who need liquidity to keep their staff and pay operating expenses.

The Fed’s second major move was announcing that it would buy assets such as corporate debts through direct lending, bond and loan purchases. This announcement immediately spurred corporate borrowing because the “lender of last resort” was back in town to save the day. Buying corporate bonds is not a problem per se but the situation became problematic when the Fed announced that it would also buy junk bonds – debts with high risk of default. The Fed is essentially backstopping the riskiest investments in the world, which are typically owned by high-risk high-reward seeking private equity firms and hedge funds.

What’s wrong with buying risky corporate debt? The problem is a moral one. In recent years, corporate profits soared – but so did debt to earning ratios. Rather than paying dividends and buying back their own stock by using their cash flow, corporations decided to do so by taking on massive debt. Since business was good, they figured that massive debts were sustainable. The Fed warned against the rapid rise of corporate debt ratios but these concerns were brushed off without second thought. Why spoil the party when everybody is having fun?

The party stopped in March. The coronavirus crisis caused business to grind to a halt and corporate cash flows immediately dried up. Debts are reaching maturity and companies who are already highly leveraged and have little cash on hand are unable take on more debt to honor their obligations. Today, the Fed is stepping in to save the same companies who took on massive leverage without thinking about the consequences. While Main Street is in the bread lines, Wall Street is being handsomely rewarded for its irresponsibe behaviour.

Isn’t Congress preparing a second bailout?

On Tuesday, House Democrats unveiled their latest coronavirus bailout proposal. The proposed bill is supposed to provide relief for states and local governments, direct payments to individuals and hazard pay for essential workers.

The proposed legislation includes:

  • Close to $1 trillion in aid for states and local governments
  • A second stimulus check of $1,200 per person and up to $6K per household
  • $200 billion in hazard pay for essential workers who were on the frontlines of the coronavirus crisis
  • $75 billion for coronavirus testing and contact tracing (a key aspect for restarting business)
  • Extension of the $600/week federal unemployment beefit payment until January
  • $175 billion in rent, mortgage and utility assistance
  • Measures to help businesses stay on employee payroll, including $10 billion in emergency disaster assistance grants and a strengthened employee retention tax credit.

The bill’s price tag is estimated to exceed $3 trillion dollars. Apparently, Republicans disagree with the contents of the bill, which some have dubbed a “liberal wishlist“, and will most likely reject it in the Senate. While political bieckering continues, the real economy’s recovery drags on and the threat of recession intensifies.

Has the USA already entered a recession?

A recession is a period of economic downturn where GDP declines for two successive quarters. The latest GDP numbers are not available yet but the US Bureau of Economic Analysis estimates that Q1 2020 GDP growth will be -4.8% and the New York Fed’s Nowcast for Q2 2020 stands at -7.8% GDP growth. If these estimates are confirmed, then the National Bureau of Economic Research – the committee who officially declares recessions – will formally announce a recession in July.

Technically, the recession has not started. Since data is not revealed in real time, the recession will be declared retroactively. The issue is that there can be huge delay between the start of a recession and its official announcement: for example, the committee declared in December 2008 that the Great Recession started in December 2007…

Given that the latest data is already very eloquent, many economists are jumping the gun and saying the US is already in a recession. In any case, everyday Americans, such as the 30+ million who have already been laid off and don’t know when they’ll start working again, sure feel like the recession has already started.

Will the market crash again?

If a recession is confirmed, a second crash could be on the cards.

Markets eventually adjust to economic reality. After the bailouts were announced the stock market bounced up predicting a quick economic recovery but if a recession is confirmed then the 2021 outlook will be dire and the markets will adjust accordingly.

Warren Buffet once said that his Buffet Valuation Indicator, which compares Market Cap to GDP, is “probably the best single measure of where valuations stand at any given moment“. Right now, the Buffet Indicator is higher than it was at its 2000 peak (right before the dot-com bubble burst).

Perhaps Warren Buffet has good reasons to sit on his $137 billion cash pile and wait this out.

Should you and I follow suit?

2 – How should investors prepare?

The most reliable strategy is to put your money in the safest havens: Cash, blue chip stocks, gold, and potentially Bitcoin.

First, raise cash. If you’re fully invested and stocks tank, you won’t be able to take advantage of the market bottom. Yes, it’s very difficult to time the market but if a second crash comes you’ll have liquidity to purchase equities at a discount. You should consider offloading your riskiest positions, even it it means selling some of them at a small loss.

Second, if you do invest, focus on companies with solid balance sheets, positive free cash flow, investment-grade credit ratings, and excellent management. Analyze debt structures and avoid highly leveraged companies with no cash on hand. Purchase companies who have track records of performing well during downturns and who may continue performing well during this crisis. Think of tech stocks profiting from the stay-at-home and work-from-home trends, online retailers, grocery stores, pharmacies, and large pharmaceutical companies. Most importantly, stay up to date on the corporate press releases of the companies you own.

Third, think about buying gold. It’s may not be the smartest move to buy gold when its price is reaching all time highs but it can provide a useful hedge against broader economic and geopolitical instability: for instance, the coronavirus has created a Saudi Arabia-Russia oil supply war and the US and China are reigniting their trade war. Gold is a proven store of value and holding a small percentage in your portfolio could prove to be a useful long term hedge.

Lastly, if you like risk, you should consider buying some Bitcoin. The recent halving reminds the world of its anti-inflationary properties and, looking at the trillions being printed by the Fed, this looks pretty appealing right now. Bitoin is a very volatile asset and there is no guarantee that a bull run is starting, but the symbolic $10K mark is close to being breached. If that happens, BTC could go on a prolonged run. Personally, I’m invested in BTC for the long run (10+ years) so the short term price fluctuations don’t affect my outlook.

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Disclaimer: I am not a financial advisor and this is not financial advice. Always conduct your own research before investing in any asset.

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