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The latest parlor game on Wall Street is all about letters.
July 2, 2020
Please read the important disclaimers at the bottom of this post. Past performance is not indicative of future results. Not a recommendation to buy or sell securities. Nothing in this presentation is intended to be construed as investment advice.

If you’ve been brave enough to turn on financial television in the last 3 months, you’ve heard it. The game is speculating on the “letter” of the recovery as the economy normalizes following the coronavirus. Are you a V-recovery person, who thinks everything will snap back to normal as soon as the virus subsides? Less optimistic? Maybe you’re a U. Expecting a double dip, which would make you a W? Expecting no recovery at all? You’d be a L-shape recovery kind of person. As each day concludes, the virus leaves us with an O, going around and around in a circle with no end in sight. As if this game of recovery letter scrabble wasn’t enough, the government response to the coronavirus has presented business owners, employees, and investors with a dizzying array of acronyms. In the last few months, we’ve been introduced to PPP, EIDL, TALF, CARES, HEROES, and others, all of which are designed to help combat the financial and economic hardship brought on by the pandemic.

While some response was required to combat the “economic induced coma” created by travel bans and forced business closures, what’s lost in this alphabet soup of government programs is that the Fed and Treasury Department have crossed the Rubicon in terms of market intervention. Yes, credit markets froze and stocks plummeted in March. The Fed responded by cutting rates and reinitiating its Term Asset-Backed Loan Facility (TALF) program, which was a great success in its previous incarnation during the Financial Crisis in 2008-2009. TALF provides institutional investors with cheap leverage to acquire AAA rated asset-backed securities, providing a nice return opportunity while stimulating lending markets. This type of stimulus is at least familiar, as it’s focused on stimulating markets through manipulating broad pools of securities. It also leaves security selection to professional allocators.

The subsequent announcements – that the Fed will buy corporate bonds (including those rated junk) through ETF purchases and individual bond purchases are more troubling. The decision to purchase individual corporate bonds as part of the CARES program is a bridge too far. The Fed announces such programs just so it doesn’t have to use them. To instill a bit of confidence in the system. And it worked. But on June 16 (the only day reported thus far), the Fed purchased $207 million of individual corporate bonds as described in its disclosures posted here under the Secondary Market Corporate Credit Facility section. The Fed is building a large book based on an index it created to get around a game of political football. Now that the Fed is operating as a credit fund in the business of owning individual securities and taking idiosyncratic risk, it requires only the tiniest leap for the central bank to start mirroring the Bank of Japan, which continues buying trillions of Yen in Japanese stocks.

Remember the good old days, back when struggling companies had to pay for their capital? Where actions had consequences? In the Great Financial Crisis of 2007-2009, the American taxpayer was at least partially compensated for absorbing the risk of reckless businesses because the federal government took an equity stake in AIG and the automakers. This time around, the airlines just backed up a truck to the Treasury, received billions of dollars in emergency funds, gave up no equity (other than limited warrant packages), did not pay a market interest rate, and made no long-term commitments to its workforce. Boeing, a company whose troubles long predate the virus, at least only used the American taxpayers as a stalking horse before raising funds through a private bond offering, including a 40-year-to-maturity tranche at less than 6% interest. Publicly traded companies abused the PPP program at the expense of small business owners, stopping only after a significant public shaming.

That doesn’t even consider the indirect ways that the Fed’s actions over time have distorted the most basic of investor behaviors. Despite the unprecedented economic uncertainty caused by the virus, both debt and equity issuance are surging. Is this a normally functioning market? Think about this: Hertz Global Holdings filed for bankruptcy, and then its stock went up nearly 10X. What causes that other than investor expectation of an equity-saving bailout?  Some might argue that retail investors are bored and a large number of them bought the stock seeing a deal without understanding the consequences of bankruptcy (your value goes to zero). However, when it was trading above $10 before March 6th, the average trading volume was in the range of 3-7 million shares per day. Right after it filed for bankruptcy, the share price went as low as $0.40 and for those first three days 609 million shares changed hands. I could be wrong, but that doesn’t seem like it’s just retail. Even now, with its stock price (somehow) higher, it still trades regularly with hundreds of millions of shares changing hands daily as it makes the news. And then the company nearly pulled off the unthinkable, as only a last-minute SEC intervention paused Hertz’ plans to sell nearly $1 billion in new (worthless) stock directly to the market while still in Chapter 11. This is the greater fool theory run amok.

There has been a lot of punditry about the other moral hazards created in the government’s response to the crisis, with many pointing to the working poor making more money through enhanced unemployment than they would at work, and those lucky enough to keep their job still receiving stimulus money. This kick down the ladder is typical of Wall Street. Many ask why the average family can’t withstand a couple months of lockdown; I’ve heard far less outrage that Delta and American Air don’t have a few months of expenses in cash on hand. Hey, stock buybacks fueled in part by cheap debt (the airlines bought nearly $40 billion of their own stock from 2015-2019) and misallocation of resources have consequences. Look, we’re not opposed to stock buybacks. They’re a perfectly reasonable way to return capital to investors in a tax-efficient manner. But this torrid pace of buybacks was a capital allocation decision made by executives, and that it left them so thoroughly unprepared to handle a crisis is a shame. Risk in business and investing is ubiquitous. Equity investors are compensated for taking this risk through owning a share of profits, but if the business falters they take losses or potentially get zeroed out. That is how capitalism functions. Or you could just bank on a bailout.

I’ve heard even less discussion about the decades-long societal trends that have created this fragile of a populace and economic system. That over half of households are unequipped to handle a temporary economic hardship is a tragedy. The death of retirement savings through destruction of the pension system coupled with stagnating real wages, the rise of the gig economy, and punishment of savings through structurally low interest rates have crippled the working class’ ability to withstand a crisis.

America’s 50-year communion at the altar of corporatism has changed the way we define productive businesses, conflating profit and production with a rising stock price. This distorted view of capitalism has left regulators and politicians more desperate to prop up stock prices as a reflection of the real economy. This stock market is valued at levels rivaled only by the start of the great depression in 1929 and the dot com bubble of the early 2000s (based on the Shiller Total Return CAPE ratio, which admittedly has its drawbacks) despite a recession, more than 40 million unemployed at peak, and rising COVID infections day after day. How does one reconcile these valuations with a country which is on a path to more infections, more unemployment, lower earnings levels, and more bankruptcies? It only makes sense if you consider the Fed’s policies and intervention, which it seems has been all that anyone needed to hear in order to feel confident about the markets.

And that’s just the problem. As people become more used to being able to rely on the Fed when times get tough, the Fed will find itself filling that role more often. As we see a market more susceptible to shocks, what sort of arsenal can the Fed continue to employ to keep markets calm? The Fed is supposed to be the lender of last resort, not a tactical corporate bond trading shop. How long until the central bank turns to the equity market to quiet investor pessimism and volatility? How on Earth will they ever unwind this trade? Any objective look at a chart of the Federal Funds rate or the Fed’s balance sheet shows that a full unwind is not really in the cards.

Look, we’re not saying that this is the end of the world. To reiterate, the Fed needed to fulfill its duties to ensure credit markets didn’t lock up. But we don’t like how it’s almost being taken for granted; the expectation is the source of the moral hazard we fear. When everyone starts to go out on a limb so much that the Fed has no choice but to intervene in order to save everyone from themselves, we don’t have true capitalism anymore, but rather a perverse version of it where gains are privatized and we all eat the losses.

Arthur Grizzle & Charles Culver
Managing Partners
Martello Investments

important disclaimers

The information contained in this presentation is qualified in its entirety by the following disclosures which must be read in conjunction with the presentation. The presentation is intended for sophisticated investors for informational purposes only and is not intended to constitute investment advice or recommendations by any party. Unless otherwise indicated, information, data, strategies and opinions included in the presentation are provided as of the byline date and are subject to change without notice. In accordance with relevant SEC advertising regulations, a full list of trades and investment recommendations is available upon request. Past performance is not a guarantee or a reliable indicator of future results. The views and strategies described herein may not be suitable for all investors. You should consult your financial advisor regarding such matters. The material contains the current opinions of the author, and such opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based on proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. This material contains information that has been prepared from original sources and data believed to be reliable. However, no representations are made to the accuracy or completeness thereof. Investing involves a variety of risks and may be only appropriate for sophisticated persons who can afford a loss of all or a substantial portion of their investment. No part of this material may, without advance written consent, be copied or duplicated in any form by any means. There can be no assurance that any client’s investment objective will be achieved or that a client will not lose a portion or all of its investment account. The investment return and principal value of any investment will fluctuate over time. No chart, graph, or other figure provided should be used to determine which investment strategies to use or which securities to buy or sell. No figure above should be taken as a recommendation or endorsement of a specific security, sector, or strategy. References to market or composite indexes, benchmarks or other measures of relative market performance over a specified period of time are provided for information only and do not imply that any client account will achieve similar returns, volatility or other results. The composition of an index may not reflect the manner in which a client’s portfolio is constructed in relation to expected or achieved returns, portfolio guidelines, restrictions, sectors, correlations, concentrations, volatility or tracking error targets, all of which may change over time. An index’s performance does not reflect the deduction of transaction costs, management fees, or other costs which would reduce returns. You cannot invest directly in an index.

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