Surviving the Economic Challenge Ahead

(Before I start, let me give a little disclaimer: This is not intended to be investment advice for any individual person or entity. This is a general talk on economics to help prepare individuals and companies for what may be ahead -and- to give ideas on how this whole thing could play out. I do not know the future; we are just discussing risk and possible opportunity. Please consult your own investment advisor before you invest in the securities markets.)

Freedom First. We are beginning to make strides to return to some level of normalcy after lockdowns for the Corona Virus. This is way overdue. For the first time in American history, the healthy people have been quarantined along with the sick.

Unfortunately, our enemies both domestic and foreign have learned that a substantial number of Americans will give up their civil rights if they are scared enough. I hope we have learned a lesson here. We cannot relinquish them so easily next time the media tries to scare us into giving them away for our protection.  

Have we forgotten that we live with risk every day? Since when did we decide to eliminate all risk from our lives as a solution to any problem? We have lived through other pandemics, the Great Depression, two world wars, Korean War, Vietnam War, and the wars in the middle east. We take risk every day just going to work. We must mitigate or eliminate risk where prudent, but we cannot allow ourselves to give up everything for safety. Life then is not worth living. We must be free, we must be social, and we must work. There is no acceptable alternative. 

Patrick Henry’s speech to members of America's Continental Congress proclaimed, "Give me liberty or give me death!" His words spurred the colonies into action and started the fires that would burn the ties that linked America to England. The cost was great, the risk was high, but we took that risk nonetheless. 

William Wallace at The Battle of Bannockurn stated clearly the challenge before his countrymen and the same challenge we face today as Americans:  “We fight not for glory, nor for wealth, nor for honor but only and alone we fight for freedom, which no good man surrenders until death.”

A number of the governors have used this shutdown as an opportunity to suppress freedom of religion. I have followed many of these civil rights cases brought against California, Michigan, New York, Washington etc. The governors determined that churches are not essential, though liquor stores, Walmart, Costco, abortion clinics, and their own jobs are of course, absolutely essential. 

Why does this matter? The foundation of all civil rights is the freedom of religion. Once freedom of religion is gone, governments know they have complete control. The Socialist and Communist governments all persecuted Christians and Jews and shut down religious freedom. Church is their enemy and they do whatever they can to silence them.

We need to protect our freedoms – if Covid 19 has taught us anything, it’s that we clearly have a lot of work ahead of us.

 Economics.  Global economics is crucial to understanding the world and getting a sense of the future ahead. I spend hours a day trying to understand what is coming and what will impact our Exit Planning clients for Long Business Advisors, LLC and our Investment clients in Long Family Office, Inc.  

We pay for research from some of the best in the industry and only use independent sources, including macro hedge fund managers and investors like Raoul Pal of GMI, founder of RealVision, Julian Bridgen of Macro Intelligence 2 Partners, Mauldin Economics and institutional firms like Ned Davis Research. I stay away from Goldman Sachs, JP Morgan, Bank of America and Wells Fargo. In the last decade especially, they have taken risk without facing consequences, and as a result have cheated and stolen from the American people. It’s important to know where information is coming from, and what their bias is to that information.

So where are we going? Well first, it’s important to understand that the United States and the rest of the world was teetering on the edge of recession prior to Covid 19. Fund managers around the world were waiting for it to happen, and the virus lockdown became the final nail in the coffin. 

The world had never been so indebted in all of history before Covid. Since Covid, the debts of the world are exploding, as governments are pouring money in to keep their economies afloat.

According to Raoul Pal, there are 3 main phases ahead of us, which I will summarize below, as well as add my own commentary.

 So where are we now and where are we going?   

Phase 1. The Liquidation Phase

It looks like we are nearing the end of the liquidation phase. In this phase, the Fed provides liquidity and blows out their balance sheet in order to give money to individuals and businesses. The second order consequences of “essential” and “non-essential” businesses has most likely destroyed many small businesses and allowed mega corporations to become monopoly-like. This is just another intervention in our economic system by politicians who believe themselves wiser and more beneficent than ourselves. 

Why does this matter? Typically in America, we allow companies that are badly run to go bankrupt, allowing good businesses to gain more customers and reallocating capital to the best companies. It is called “creative destruction”, because when those businesses fail, their employees, inventories, and technology flow to businesses that are better serving their customers and more efficiently using their capital. Entrepreneurship is built on the concept that those who do it better reap the rewards. In short, creative destruction is the bedrock of capitalism.

However, our politicians have decided to muddy the waters by backstopping big banks in the 2008 recession, and now by buying corporate bonds from those who decided to buy back their own stock instead of saving it for hard times. Both entities in capitalism should have failed; instead, they are being propped up with government support (read: taxpayer money).

It’s like parents watching their adult children spend all their money on clothes and cruises, and then paying their rent for them when they come home crying that they can’t make ends meet.

Our states have largely done the same thing. Overspending in many blue states has left pensions underfunded and the state in deep debt. Just like children, they need to suffer the consequences of their mismanagement. Unless there are consequences for some, there will be consequences for all.Ultimately, the government is destroying the system that made us great – ideas and morality that were based on a Biblical understanding.

Now that the liquidation phase is winding down, things are also calming down as the economy reopens. Bankruptcies haven’t started yet and volatility is down in the markets. People are optimistic – they can finally go outside and hopefully return to normal! The hope phase has begun – the calm before the storm.  

Phase 2. The Hope Phase.

The hope phase is a direct result of the liquidation phase. Because the government is throwing helicopter money to states, businesses, and families, we are feeling pretty good even though we haven’t worked much in the last two months.  

People are feeling so good that many of my business clients are having trouble reopening or staying open because they can’t find workers. The government has raised unemployment benefits so high, people are getting more money than they were at their jobs! They have been incentivized to stay home and so they are staying home. Unfortunately, many do not understand that jobs are not guaranteed at the end of this shutdown. 

In the hope phase we bask in the moment, not realizing what is yet to come. Enjoy it while it lasts, but prepare for the next phase, for a total world economy shutdown will not be overcome easily or quickly.

David Rosenberg, of Rosenberg Research says that the odds of a quick recovery are virtually zero. Looking at history, we’re in for a slog. The bear markets over the last century provide much insight into the what may come in the next phase .

Let’s start with 1929 and the Great Depression. After the initial decline of about 35%, (as we had in March) the Dow rallied toward a 50% recovery over six months. Everyone was relieved as it looked like the world was on the way back to normal. Unfortunately, that rally only lasted so long, and by 1932, the Dow was down by 86.1%. 

In 1990, the Japanese went through a similar bear market. The Nikkei, like the Dow in 1929, bottomed in March, and regained 50% of its losses. It also peaked in June and double peaked again in July, and then dropped like a rock, losing 61.6%.

Back to America and the 2001 bear market. The market peaked in March, dropped hard and then peaked again in September, regaining just over 50% on the bounce back. But like the other recessions, the market dropped 49.1% over the next 18 months. NASDAQ during the same period dropped about 78% from the dot.com bubble.

Finally, we consider the 2008 crash. Again, we had basically the same thing for almost all of the bear markets. March was the low. June was the high. It retraced to recover just over 50%. Then, the market went on to drop 56.1%.

What’s the point? A pattern is a pattern, and this looks very much like one to me. Our 35% drop in March of this year fell in similar percentage to most all of the other bear markets. Our bounce has been a little higher (over 60%) than the other markets we have considered, but we have more money being thrown at the problem by the government than at any other time.

We do not yet know what happens from here. The question is, do we continue much higher? My best guess is no. Beneath the surface, something else is brewing that will weigh heavily on the markets. The insolvency phase is coming, and soon.

 Phase 3. The Insolvency Phase.

The insolvency phase is the one that can be the most terrifying. We could trade sideways here in the Hope Phase for a few months or even go a little bit higher, but this phase is coming to an end. It may be extended for a while if the government continues to give away money and/or buy stocks and bonds in the markets, but at some point, it must end. In the insolvency phase, there is a potential that we may see a debt deflation similar to the Great Depression. Will it be better or worse? One can only guess. All we know is that if it comes, it won’t be any fun.

What is a debt deflation? Prices fall as business slows down. The velocity of money falls. People start to believe that if they wait a little longer to buy things, the prices will drop. So they don’t spend the money. They wait. People and governments start to really protect their cash. Defaults on loans start to happen, and bankruptcies begin – individuals, companies, and state governments. This debt deflation creates what Raoul calls the Doom Loop.

Consider the things that push that Doom Loop forward. First, the world is awash in debt right now. US corporate debt as a percentage of GDP is the highest it's ever been and the money borrowed was mostly wasted. Companies bought back their own company stock, which made management and investors rich, but did nothing to add to the actual value of the company. Increased risk to shareholders and investors, but no productivity increases or R&D to make the company more valuable. In short, they borrowed to make themselves rich.

Another problem on the horizon has to do with BBB-rated bonds. These bonds are one level above junk bonds, and include GE, Ford, and a bunch of other big names. If the debt deflation causes them to fall into the junk category, it would force a whole host of investors to sell – as many funds are unable to hold junk bonds because of their investing rules. Why is that a problem? BBB-rated bonds are 2.5 times the size of the junk bond market, to the tune of $4 trillion dollars. Forced selling among investors to this magnitude could destroy the bond market, akin to what we saw in mortgage bonds during the financial crisis a decade ago.

Remember, when the Fed provides money to companies, the goal is to provide cash flow. But in the solvency phase, revenues drop so hard it’s impossible to continue to pay the debt, no matter how much the government is providing. The substantial loss of revenue for corporations would be the catalyst for the downgrading of the BBB’s to junk bond status.

Take restaurants for example. The restaurant industry survives on very slim margins – can they stay afloat at 50% capacity? We’re about to find out. Social distancing may very well kill their profitability entirely. It’s not just the restaurant industry, many businesses rely on people coming in the door and without normal foot traffic, many businesses are unprofitable.  

Unemployment also comes to play in this phase. We are sitting with about 23.1 million people unemployed right now, which is up 15.9 million over the last month! Once revenues begin to drop, we estimate unemployment will skyrocket yet again.  

As I mentioned earlier, consumer behavior has changed dramatically the last 3 months. Instead of going out and spending money, people are staying inside. Many fear a second wave of Covid 19. According to recent polls, 40% of people are not ready for the reopen – this obviously points to lower company revenues. I believe we are going to have a truly shocking drop in GDP in the second quarter. By the third quarter we may pick up again, but we’ll probably see at least 9-18 months of reduced cash flows for businesses in general.

The debt issues don’t end with corporations. We have government debt and individual debt. Student loans and auto loans are currently in a bubble that will pop. 

Oil prices and commodities have fallen, as global trade has screeched to a standstill. Many believe that inflation is on the horizon due to all the helicopter money, but there is a little chance of that.

The velocity of money is falling. Banks are hoarding cash and families are pouring money into their savings to try and give themselves a cash buffer. No matter how much money we print, it won’t be enough if no one is spending it.

We’re heading for a problem with not many solutions. We have the largest debts the world has ever seen as a percentage of global GDP and interest rates near zero. We have a worldwide solvency crisis on the horizon. 

If deflation hits the way we anticipate, we expect the stock market to grind down for a year or two, as in previous bear markets, unless the government manipulates the markets in a way never seen before. It is also very possible that interest rates will go to zero in the US.

Conclusion.

We could be headed for a couple of tough years ahead, so prepare for it while we are in the Hope Phase. If interest rates are headed down still, government bonds should hold for a while. But be very wary of corporate bonds. 

There is a possibility that we will have a rise in the stock market for a while based on the government buying stocks and bonds, so we continue to hold some stock for the near future. But the rise won’t last forever. We are in one of the most overvalued markets in history with an expected 10-year forward return on stocks of 0-2%. That is not a great risk reward ratio, so think hard about being overweight in stocks.

I think owning some physical gold would be wise at this phase as well. In general, aim to own assets without debt attached to it. 

Bitcoin is another interesting investment. It’s outside government intervention for now, so it’s in a unique place to benefit from the current environment. A good place to start is to set up a Coinbase account for yourself and buy some Bitcoin and maybe some Ethereum. If this works out as we hope, it won’t take a big investment to positively impact your portfolio.

Remember, no one knows exactly how this will turn out, but it is a time to be wise, reduce debt, and raise some cash. Shore up your defenses and get ready for the opportunities to come. Recession or depression ahead, there is always opportunities to be had!

(Again, this is not intended to be investment advice for any individual or entity. This is a general discussion on economics to help prepare individuals and companies for what the future may hold. Reach out to your own investment advisor for help and personalized advice. Make sure you have a good CPA to plan with you.)

And finally, if you are a business owner, consider hiring a business coach/consultant to help you navigate these next few years. Even the greatest and smartest business owners and athletes have coaches. You likely need one too, now more than ever, if you are not already clients of Long Business Advisors, LLC.

Godspeed my friends,

Randy M. Long, CFP, Esq., CExP