May 13, 2020

The Intelligent Investor's Market Memo

The Fed Gave Investors A Gift, It's Time To Sell In May and Go Away

In April, the S&P 500 rallied by 12.7%, and had its best month in thirty-three years, despite more than 30 million job losses due to the coronavirus economic shutdown.  In late-February and March, pandemic fears drove the S&P 500 lower by 35.4% over 23 trading days, which was the fastest 30% decline in market history. The market crash ended on March 23rd when the Fed announced that they would purchase an unlimited amount of Treasury and mortgage-backed bonds. The S&P 500 has rallied by 34.8% in the seven weeks since the Fed’s unprecedented announcement.

Currently, the economy is in its most severe recession since the Great Depression, the unemployment rate is the highest in ninety-years and there is immense uncertainty over the magnitude and duration of the pandemic and the recession. Despite this precarious environment, the S&P 500 is down by only 11.2% year-to-date and has fallen only 0.4% over the past twelve months.

Despite the coronavirus pandemic, a market crash, and the worst recession since the Great Recession, stocks are priced for perfection and, in our view, offer a very poor risk-reward.  Since March 4th, the Fed has “printed” $2.5 trillion to stabilize financial markets and inflate stocks. This massive liquidity injection, coupled with quantitative investment strategies -- that invest based on price and volatility trends instead of fundamentals -- have driven stocks to an irrational level.

As value investors, we believe that the best way to grow your wealth, and compound at a high rate is to avoid significant losses in high-risk periods such as today. In our view, stocks offer a very poor risk-reward, and we believe that prudent investors should take advantage of the “Fed’s gift” and reduce their risk exposure.

Our long-term concerns:

  • We are less than two months into the worst recession since the Great Depression. More than 30 million people have lost their job, and the duration of the virus and the recession are unknowable. Social distancing eliminates the chance of a V-shaped recovery, and the economy can’t return to normal until a vaccine is available, which is at least a year away.
  • The Coronavirus will accelerate the move away from globalization, as countries adjust their supply chains to become more self-reliant. Reorganizing supply chains will lead to short-term disruptions that could create more economic stress. Longer-term, declining globalism will lead to more domestic jobs, at the expense of high prices and lower profitability.
  • Valuations are at record highs, corporations have a record debt burden, and share buybacks will be limited
  • Over the past twelve months, profits are down 13.6% while the S&P 500 is down only 0.4%. According to FactSet, analysts expect earnings to fall by 40.6% in Q2, 23.0% in Q3, and 11.4% in Q4. Unfortunately, this massive decline in earnings will lead to debt downgrades, delinquencies, and defaults.
  • We are in a bear market. Most stocks peaked in 2018, and are down significantly over the past 2.5 years

Our short-term concerns:

  • Stocks are extremely overbought
  • Market breadth is weak, and seasonality is negative
  • Significant divergences between stocks, bonds, and commodities exist
  • Financial stocks are performing poorly, which is not consistent with an economic recovery, or a new bull market
  • Quantitative strategies -- that ignore fundamentals and invest based on price and volatility trends -- are dominating trading. These strategies ignored the spreading pandemic and helped drive the S&P 500 to an all-time high on February 19th. Once the uptrend broke, these strategies quickly reversed and significantly contributed to the market panic. Today, these strategies are pushing stocks higher and ignoring an unprecedented economic risk. We are concerned that once the seven-week uptrend breaks, another sharp sell-off will occur.
  • Finally, it is not reassuring that famed value investor, Warren Buffet, had $137 billion in cash, but didn’t make any investments during the financial panic. Instead, he eliminated his airline investment and bought back only $1.7 billion of Berkshire’s shares despite a 30% drop. The $1.7 billion share buyback was less than any quarterly repurchase in 2019. During his annual meeting on May 2nd, Buffet stated that “we have not done anything because we haven’t seen anything that attractive to do.”

Brief Market History:

Markets were vulnerable before the Coronavirus struck. Since the 2008 Financial Crisis, the Fed has continually intervened in financial markets to reduce volatility and inflate stock prices. Unfortunately, a decade of profligate monetary policies has led to significant unintended consequences and structural imbalances.

After the 2008 Financial Crisis, the Fed engaged in a policy of financial repression -- negative real interest rates and printing money to buy bonds (QE) -- for nearly ten years. The Fed believed that QE and artificially low-interest rates would stimulate the economy by reducing borrowing costs and inflating stocks. Higher stock prices would make investors wealthier and lead to more consumption (the wealth effect).

Short-Term Interest Rates Were Below Inflation for the Past Decade.

Artificially low-interest rates led to higher stock prices, too much debt, and malinvestment

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Our View:

In the short-term (three-months): Our short-term outlook turned positive on March 20th, after stocks crashed down 34% in only 23 trading days. Since investors were fearful, stocks were historically oversold, and breadth and volatility positively diverged, we believed that the market had a favorable short-term risk-reward. Today, the market is the mirror image of the March 23rd low – stocks are extremely overbought, breadth is weak and significant divergences exist. Our short-term market outlook is neutral, and we will become negative if the S&P 500 closes below 2800.

In the long-term (more than four years): stocks are in a bear market, and we continue to believe that the equity market offers a poor long-term risk-reward. Central bank liquidity and not economic fundamentals drove shares far from their intrinsic value. The global economy was vulnerable before the Coronavirus, and now there is significant uncertainty about the magnitude and duration of the worst recession since the Great Depression. Despite the market crash, stocks remain overvalued, corporations have too much debt, and earnings are in a recession. We will remain defensively postured until the market offers a favorable risk-reward, i.e., valuations improve, and economic growth accelerates. Our Strategic Asset Allocation is underweight equities relative to our benchmark; we are overweight the defensive sectors of the S&P 500, and overweight the safe havens (gold and the U.S. long-bond).

The Fed’s policy of financial repression drove stocks away from their intrinsic value. In 2001, Warren Buffet told Fortune magazine that Marketcap to GDP “is probably the best single measure of where valuations stand at any given moment.” Today, stocks sell at a record 1.4 times GDP, which is more than three standard deviations above the historical average level. Stocks would have to decline by 45% to be fairly valued.

The Market Value of Stocks Relative to GDP is at a Record

The Fed’s profligate monetary policies have driven stocks far from fair value

Source: FRED

While the Fed successfully inflated stocks, the “wealth effect” did little to stimulate the economy. In fact, financial repression led to weak economic growth. From 2010 through 2017, the economy grew on average at 2.1%, which is significantly less than the economy’s 3.2% average growth rate since WWII.

Despite Unprecedented Monetary Policy, Economic Growth Disappointed

Negative real rates and QE pushed up stocks but didn’t fuel robust economic growth

While financial repression didn’t stimulate the economy, it did encourage corporations to borrow a record amount of debt. Artificially low-interest rates incentivized corporations to engage in financial engineering – i.e., borrowing money to buy back their stock, instead of building or investing in R&D.

According to the Harvard Business Review, over the decade ending in 2019, companies in the S&P 500 spent $4.3 trillion on buybacks, which is equal to 52% of net income. In 2018, buybacks by S&P 500 companies reached an astounding 68% of net income.

Stock buybacks are a distribution to shareholders and management that do nothing to improve the company’s competitive position or increase economic productivity. According to the Harvard Business Review, only 43% of S&P 500 companies recorded any R&D expenses in 2018, and 38 companies accounted for 75% of the R&D spending of all 500 companies. It appears that corporate buybacks came at the expense of long-term capital investment and R&D.

Financial Repression Led More than $4 Trillion in Share Buybacks

Corporations bought back their stock instead of investing or saving for a” rainy day.”

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Financial Repression Led to Weak Investment Spending

Corporations used cheap debt to fund share buybacks instead of investing in productive assets

The significant unintended consequence of the Fed’s profligate monetary policy is that the corporate debt burden has never been higher, which is especially concerning since we are in the worst recession since the 1930s.

Also, artificially low rates and inflated risk assets led to an increase in zombie companies – i.e., companies that need to borrow to service their debt burden. According to Ned Davis, 36% of Russell 2000 companies were unprofitable before the pandemic stuck, and 55% of small-cap companies have interest coverage ratios (EBIT/interest expense) less than three.

Financial Repression Led to a Record Corporate Debt Burden

Corporate debt is at a record 46.5% of GDP

Approximately 50% of investment-grade bonds are rated BBB, which is one level above junk. We are concerned that as the economy contracts, debt downgrades, delinquencies, and defaults could turn a severe recession into a debt crisis.  Currently, corporate bond spreads remain elevated, despite the Fed’s intervention in the corporate credit market. It appears that the Fed can use its balance sheet to paper over liquidity problems, but it can’t prevent insolvency issues.

Credit Spreads Remain Elevated Despite the Fed's Intervention

For the first time ever, the Fed is buying corporate credit. Unfortunately, solving insolvency issues is harder than liquidity issues

In addition to inflated stock prices, overleveraged corporate balance sheets, and dismal economic growth, financial repression led to other unintended consequences. High stock prices and weak economic growth led to deteriorating living standards and rising wealth inequality. Wealth inequality hurts economic growth and leads to social unrest. Also, rising wealth inequality has led to an increase in populist and nationalistic political views throughout the globe.

The Fed grew its balance sheet from $900 billion before the Financial Crisis to $4.5 trillion in 2014, when they finally stopped printing money. Eight years after the recession ended, the Fed decided it was time to normalize its interest rate policy, and they increased short-term interest rates three times in 2017 and four times in 2018, which brought the Fed Funds rate to 2.5%.  Also, in October 2017, the Fed began to reduce its bond holdings through its Quantitative Tightening policy. By 2018, Quantitative Tightening was “selling” $50 billion of bonds each month.

The Fed’s Balance Sheet

From 2008 through 2014, the Fed printed and bought $3.6 trillion of bonds, which inflated risk assets and artificially lowered interest rates

Unfortunately, the Fed underestimated the impact that higher interest rates and Quantitative Tightening would have on the financial markets and the economy. The S&P 500 plunged by 20% in the fourth quarter of 2018 after the Fed continued to tighten monetary policy despite a sharp market correction.  The market correction ended, and a sharp rally began when Fed Chairman Powell stated, “We’re listening carefully with – sensitivity to the message that the markets are sending and we’ll be taking those downside risks into account as we make policy going forward.”

In December of 2018, the Fed estimated they would increase interest rates two more times in 2019, and Quantitative Tightening would continue for the foreseeable future. Instead, disappointing economic growth due to the Fed’s tightening cycle and the trade war with China led the Fed to cut interest rates three times in 2019 (which erased all of their 2018 rate hikes) and they ended Quantitative Tightening in July.

Stocks rallied as the Fed cut rates in 2019, but an unintended consequence of the Fed’s Quantitative Tightening policy emerged. In September of 2019, the repo market (overnight lending market) froze due to a lack of dollar liquidity. The Repo market, which is a critical component of the global financial plumbing, last froze-up during the 2008 financial crisis as institutions feared counterparty risk and refused to lend.

In October, the Fed announced that they would increase liquidity to “repair” the Repo market, by printing $60 billion each month to buy U.S. Treasury bills. The Fed’s attempt to paper over the Repo market problem led the stock market to explode higher by 18.8% from October low to its February 19th high.

Summary: Since the Financial Crisis, the Fed has attempted to manage asset prices and reduce volatility to create a wealth effect that would stimulate economic growth. Wall Street did great (record-high stock prices) while Main Street suffered (declining living standards and wealth inequality). The Fed’s unprecedented monetary policies did not stimulate economic growth. Instead, it led to structural imbalances -- bloated corporate balance sheets, zombie companies, malinvestment, and significant wealth inequality -- that will make navigating the current recession more difficult.

Current Market Outlook:  When the S&P 500 reached an all-time high on February 19th, it sold at more than 19 times forward earnings, which was the highest level since May 2020. When the Coronavirus virus struck, the markets were priced for perfection. Stocks were overbought, and investors were ebullient despite overvaluation, negative earnings growth, and weak market breadth. Also, the stock market began to diverge from the bond and commodity markets, which typically indicates that stocks are vulnerable to a correction.

Additionally, since market volatility was very low, systematic investors – quantitative funds that invest using price momentum and volatility signals – had highly leveraged positions in stocks, bonds, and commodities.

In late February, the market sharply sold-off as investors feared the uncertain impact of the Coronavirus on their health and the economy. While a bear market and recession were inevitable because of the necessary economic shutdown, we think the market crash (the 34% decline in 23 trading days) was caused by structural issues that led to a negative feedback loop of accelerating selling.

Similar to portfolio-insurance, which amplified the selling that led to the 1987 crash, leveraged systematic-investors were increasingly forced to sell assets to reduce their leverage and investment exposure. The more the market declined, the more they needed to sell. This vicious cycle of selling spread from equities to nearly every financial market – e.g., funding, credit, mortgage, municipal, Treasury, and commodity.

The massive selling and deleveraging led to illiquid financial markets with few buyers. Despite the Fed’s attempts to provide liquidity to stabilize financial markets, the selling continued.  On March 23rd, the Fed essentially stated they would do whatever it takes to stop the financial panic, and they unleashed their Unlimited QE monetary policy to halt the market crash. 

While the Fed stopped the crash and stabilized the financial markets, Congress passed the $2 trillion CARE fiscal stimulus bill. This plan is 10% of GDP, which is twice as large as the fiscal stimulus plan adopted in 2008 during the financial crisis.

In a matter of weeks, the Fed and the government have taken unprecedented measures to stabilize the financial markets and support the economy. Although this massive monetary and fiscal stimulus ended the financial panic, we believe that we are still in a bear market, and the recession is far from over.

The S&P 500 has rallied by 34.8% in seven weeks, despite an economic shutdown that caused more than 30 million job losses. Many can’t understand how the market can rally despite the terrible pandemic and economic news. We believe that stocks are higher because the Fed printed $2.5 trillion to buy financial assets. Incredibly, they increased the size of their balance sheet by 44% in less than two months.

QE Unlimited Drives Stocks Higher

Over the past seven weeks, the Fed grew its balance sheet by 44%, and stocks jumped by 34.8%. Unfortunately, the Fed’s liquidity can’t cure insolvency issues.

In addition to the Fed’s unprecedented monetary expansion, stocks were again driven higher by quantitative investing strategies that ignore fundamentals and invest based on price and volatility trends. In February, these strategies ignored the spreading pandemic and helped drive the S&P 500 to an all-time high on February 19th. Once the uptrend broke, these strategies quickly reversed and significantly contributed to the market panic. Today, these strategies are pushing stocks higher and ignoring an unprecedented economic risk. We are concerned that once the seven-week uptrend breaks, another sharp sell-off will occur.

Despite the Fed’s consistent effort to artificially inflate asset prices, most stocks peaked in January of 2018 when the Fed accelerated their attempt to normalize interest rates. Over the past two-and-a-half years, most stocks have lost money, while the safe havens (gold and the long-term U.S. Treasury bonds) have performed very well.

January 2018 High

May 12th, 2020

S&P 500




Dow Jones Industrials




Nasdaq Composite




S&P 600 (small-cap)




MSCI EAFE (international) – (EFA)




Emerging Markets (EEM)




S&P Financials – (XLF)








U.S. Long Bond -- (TLT)




In our view, the Fed’s liquidity and Quant strategies drove the market to an irrational extreme that is similar to the February peak. Market breadth is weak, and divergences exist that portend another market decline. Despite the 34.8% rally, market breadth is weak. Currently, only 17.0% of NYSE stocks are above their 200-day moving average, so 83% of NYSE stocks are in a bear market. Also, the 11-day advance-decline line peaked four weeks ago, while the S&P 500 powered higher (chart). Weak market breadth indicates a poor risk-reward and portends a market correction.

Despite an Epic Market Rally, Most Stocks Remain in a Bear Market

The S&P 500 has rallied by 34.8%, yet 83% of NYSE stocks are below their 200-day moving average, and the markets advance-decline ratio peaked four weeks ago. Additionally, enthusiastic investors are speculating by purchasing too many calls relative to puts.

According to Goldman Sachs, Facebook, Apple, Amazon, Microsoft, and Google account for 20% of the S&P 500. This extreme concentration exceeds the level reached during the tech bubble of 2000. It is typically a negative sign for the markets when a handful of stocks drive the market, and it indicates that investors are risk-averse.

In addition to weak market breadth, there are important market divergences. The S&P 500 has rallied significantly, potentially indicating that the market is discounting an economic rebound. Unfortunately, the 10-year U.S. Treasury bond, WTI oil, and copper due not confirm the stock market’s strength and indicate continued economic weakness.

Bonds and Commodities Do Not Confirm the Stocks Market’s Strength

While stocks have rebounded, bonds and commodities have languished, which indicates a weak economy

According to Ned Davis, financials are a strong early cycle sector, which typically outperforms the market about five months before the start of an economic expansion.

Unfortunately, the financials are the second-worst performing sector (behind energy) over the past twelve months and they recently hit a new relative strength low (see chart).  Finally, since the FAAMG (Facebook, Amazon, Apple, Microsoft, and Google) stocks continue to dominate, there has been no change of leadership, which is not consistent with a new bull market.

Financial Stocks are Underperforming the S&P 500

The significant underperformance of the Financials indicates that the economy is not poised to rebound, and we are not in a new bull market.

Finally, we are entering a period of unfavorable seasonality. May is the beginning of the “Worst Six Months” for the S&P 500, so it may be wise to “Sell in May and go away.” According to the Stock Trader’s Almanac: over the past 69 years, the bulk of the stock market’s gains have occurred between November through April, and the period between May and October has shown a slight loss over that period.

Conclusion: Since the 2008 Financial Crisis, the Fed’s profligate policy of financial repression (negative real rates and printing money to buy bonds) drove stocks far from their intrinsic value. It led to an unprecedented debt accumulation by corporations and financial institutions over the past decade. Also, the Fed’s consistent interventions in financial markets to support prices and reduce volatility have damaged the price discovery process and led to excessive risk-taking and financial leverage.

When the Coronavirus struck, the market was priced for perfection, despite a slowing economy and flat corporate profits. When the market broke, quantitative investment strategies that invest on market signals and not fundamentals created a vicious selling cycle that didn’t end until the Fed promised to print an unlimited amount of money to stabilize the markets. The Fed printed and bought $2.5 trillion of bonds over the past seven weeks. The Fed’s huge liquidity injection of $2.5 trillion, coupled with Quant strategies, drove the S&P 500 up 34.8% in the past seven weeks.

Currently, more than 30 million people have lost their job, and we are in the deepest recession since the Great Depression. Until a vaccine is available, the economy can’t return to normal. Also, the economy will be very different post-corona as countries diversify their supply-chains to become more self-reliant. The magnitude and duration of the two-month-old recession are unknowable, yet stocks again appear to be priced for perfection, while so much could potentially go wrong. We believe that the market offers a very poor risk-reward, and prudent investors should take advantage of the “Fed's gift" and reduce their risk exposure.

About the Author

J. Lawrence Manley, Jr., CFA has always had a passion for investing and has been lucky enough to spend nearly 25 years managing investment portfolios for pension funds, endowments and high-net-worth families. In his experience, there are two major obstacles preventing individuals from reaching their investment goals: Wall Street and Human Nature. Manley Capital was founded to overcome these obstacles and partner with clients to achieve their financial goals.