S&P 500 nears a new record!
It’s a shocking statement considering the economic environment. Unemployment is at 10%, personal income after backing out government assistance is still in the tank, entire industries are at risk of failing, and S&P 500 earnings are down about 30% from year-end 2019 levels.
How are stock prices on the verge of hitting a new high?
Look no further than the extraordinary actions of the Federal Reserve.
That’s not meant to be a compliment.
The Fed printed trillions in a matter of weeks and their actions to bail out everything–from money markets to primary dealers, to commercial paper markets, to leveraged hedge funds, to leveraged companies–is probably the greatest single moral hazard event in history.
The Fed’s extraordinary actions limited the depth of the financial markets’ downturn some, but the damage and real calamity of this intervention are still to come.
Under the auspices of helping consumers and businesses because COVID wasn’t their fault (as if normal recessions are their fault) the Fed crossed redlines it will never come back from. Investors and businesses will take on ever greater risk and leverage to boost their incomes and returns because the Fed will always be there to provide a bailout.
We see at least five areas where the Fed’s bailouts are likely to lead to bigger problems in the future.
Bond ETFs
During the height of the uncertainty in March, bond market liquidity dried up. Corporate bond ETFs crashed with prices trading at wide discounts to asset value. The price of the popular iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) fell to a 5% discount to asset value.
At Young Research we have long advised against bond ETFs for this very reason. If you buy a bond ETF at $100 per share that generates 2% in interest income per year and the price drops to $95 even though the value of the bonds in the ETF are still worth $100 per share, you’re down 3%.
The wide discount on LQD only lasted a few days though. Jay Powell came to the rescue of bond ETF sponsors and investors. On March 23, 2020 in an unprecedented, and probably illegal, move the Fed announced that it would take Treasury Department money, turn itself into a hedge fund (not really), and buy $10 worth of corporate bonds and corporate bond ETFs for every dollar provided by the Treasury. The discount on LQD closed immediately.
Bond ETFs are likely to get much bigger as a result of the Fed’s actions. This is a disappointing outcome. Bond ETFs are structurally flawed as there is a mismatch between the liquidity of the ETF itself and the assets held by the ETF. Even if he doesn’t want to, during the next crisis, Jay Powell or his successor will likely be forced to provide another bailout (probably on a much bigger scale) to bond ETFs. So much for market discipline.
Overleveraged Businesses
ETF investors weren’t the only beneficiaries of the Fed’s unprecedented intervention in the corporate bond market. Overleveraged companies were also saved. The lesson should have been to borrow less and be sure to have some cash set aside for a rainy day. Instead the lesson learned was, “the Fed will be there, so I can leverage up my balance sheet to buy back stock or earn a greater return on equity (think mortgage REITs). “
Commercial Paper
The Fed once again had to come to the rescue of the commercial paper market. Commercial paper is loans issued by companies with short maturities. The Fed bailed out commercial paper markets in the 2008/2009 financial crisis and they had to do so again in March. If a bailout is required every time there is a significant economic event, maybe companies should avoid short term funding markets.
Prime Money Markets
The Fed also bailed out prime money markets in March. Prime money markets are significant investors in commercial paper, so if you fix one you may fix the other. Regulations were put in place following the 08/09 financial crisis to prevent runs on money markets. They apparently didn’t work. The Fed had to provide over $50 billion in liquidity to money market funds to prevent a disorderly liquidation of assets. If the Fed is going to bail out prime money markets every time there is a problem, maybe they should pay an insurance fee to the government. Commercial banks pay for the FDIC insurance they offer to customers. Why shouldn’t money market funds pay a liquidity insurance fee?
Stock Valuations
This is the big one. In most recessions, the high-flying stocks valued at levels that assume a permanent prosperity take it in the neck much more than stocks trading at already depressed valuations. Not this cycle. Powell & Co’s fast actions (along with the nature of this downturn) saved investors in these highly speculative shares from a painful reconciliation. As a result, investors have doubled down on the idea that valuations don’t matter. We assure you they do. Some of the values we are seeing in COVID beneficiary stocks rival dotcom-era exuberance.
The dispersion between the valuations of expensive stocks and cheap stocks is nearing the widest on record. That doesn’t bode well for the relative performance of expensive stocks. If you are looking for actionable advice, many of the expensive stocks dominate the weightings in index funds and ETFs.
Fed Intervention is the Double-edged Sword that Will Slice You in Half
The Fed is the institution to thank for saving the day in financial markets. But the Fed is also going to be the institution to blame for the next crisis that is likely to be bigger, badder, and require much more money printing and debt issuance to solve because of the actions they took in March.
Capitalism doesn’t work without failure. That seems to be a lesson our policymakers have forgotten or no longer have the nerve to admit.
If you favor free markets and free enterprise, where investors and businesses are free to succeed as well as fail, End the Fed never sounded so appropriate.
