Making Sense of Irrational Markets and Conflicting Data

21 Apr, 2020

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This is how an economy is destroyed: ignore small businesses because small isn’t beautiful but complicated, cumbersome, risky, and a nuisance.

US commercial banks charged with the distribution of the $349 billion federal credit line earmarked for troubled companies under the Paycheck Protection Program apparently have allowed larger businesses to jump the queue. Though legally mandated to process applications on a first-come-first-served basis, a number of banks chose to first complete larger loans that earn them more in commission and fees.

Four banks are now being sued in federal court by clients who allege that the processing of their applications was unlawfully delayed. To prove their case, the plaintiffs submitted data released by the Small Business Administration (SBA), the agency charged with coordinating the emergency loan programme. In the two progress reports published so far, the SBA shows that its largest lender – identified only as ‘Lender 1’ – requested guarantees on some $14 billion in business loans with an average size just north of $500,000.

In a remarkable coincidence, JP Morgan Chase on Sunday reported that it had processed the exact same volume of emergency loans with a similarly sized average. Chase is one of the banks now being sued over unfair practices. It denies the charge and says that no businesses ‘large or small’ have been prioritised. Since the lawsuits were filed on Tuesday last week, the SBA reported a sudden increase in the number of smaller loans submitted to the agency.

However, late last week the federal credit line maxed out. Lawmakers in Washington now consider adding another $300 billion to the programme. The urgency of a Congressional deal became clear after the Bureau of Labour Statics reported that another 5.5 million American filed for unemployment benefits, pushing the tally of jobs lost to the pandemic since 14 March to well over 22 million. The federal programme to protect paycheques does not seem to have much of an impact. Or, even more worrisome, the corona recession is much deeper than can be seen from the surface.

It is the lack of sensible hard data about the present state of the economy that keeps the stock market in suspended animation. Dwelling in a barren no man’s land between bulls and bears, investors have almost nothing to go on as they mull future moves. Thankfully the market is no longer in free fall and has even clawed back some of its earlier losses. Stock prices have ‘bottomed’ and veered back even as bad new kept coming. Investors now wonder to what degree the rally of the last few weeks can be trusted.

Quarterly earnings reports, due to trickle in over the next few weeks, seem to indicate that the market is out of tune with corporate reality. Rising share prices do not square with plunging profits, leading investors to believe that the market is overvalued, if not outrageously expensive. A product of what may be dubbed the ‘ultimate externality’, depressed corporate earnings and the likewise sorry condition of the overall economy give analysts few clues about the direction of the market. Good news, such as early signs that the infection’s curve seems to be flattening, is immediately offset by bad news such as the unprecedented rise in unemployment numbers.

Given the that profits have shrunk considerably, pushing price-to-earnings ratios to highs not seen in twenty years, investors are understandably reluctant to tiptoe into a market that has plenty of downside exposure. Just two weeks ago, profits at companies listed on the S&P 500 index were expected to shrink by 10 percent on average. That number has now been revised to 25 percent. Adding to the conundrum is the fact that the first quarter also includes a good five to six weeks of ‘normal’ pre-pandemic corporate performance. This may hide the true depth of the recession.

Then again, given the trillions of dollars being pumped into the economy, exiting the market altogether may well mean losing out when the bulls stage a comeback. However, set against this dark backdrop, the tentative market rally of the past few weeks makes little sense and could well represent a triumph of will over reason.

History does, again, provide a few pointers. Big market collapses such as those of 1987 and 2008 adhere to a roughly sketched playbook: an initial crash is followed by a fairly strong rebound that fizzles out when previous lows are put to the test before the market finally ‘washes out’. This dynamic is driven to a rather unsettling degree by investor psychology, in particular the lure of ‘revenge trading’ which moves the rebound before reason prevails.

A scarce commodity in even the best of times, reason is hard to come by during this pandemic as illustrated by the price of oil. As reported here last week, wellhead prices in landlocked fields dipped below zero for the first time in recorded history, forcing producers to actually pay ‘buyers’ for every barrel of oil delivered. The topsy-turvy world of negative interest rates, another ludicrous feature of present times, just got another dimension.

The predicament of oil producers is caused by an acute shortage of storage capacity as tank farms are topped up whilst demand for fuel evaporated. Due to the high cost of the logistics involved, inland producers such as those operating fields in Alberta and North Dakota are shut off from floating storage platforms and have nowhere to ship their oil. West Texas Intermediate (WTI) futures that expire in May dropped to an astonishing minus $37.63 on Monday. WTI futures are usually set for delivery at Cushing.

That small Oklahoma town sits at the junction of several important pipelines and is home to the world’s largest tank farm with a capacity to store 76 million barrels of crude. Cushing is now nearing the point at which operators can no longer accept any additional oil. Meanwhile, an armada of close to a hundred tankers holding an estimated 160 million barrels of oil rides at anchor off the Texas Gulf Coast. Ships continue to arrive daily, adding an average 2 million barrels of crude to the offshore inventory.

Though WTI futures today crossed back into positive territory in early trading, wellhead prices for more obscure grades of crude at distant inland terminals have not. The oil market now eagerly awaits the reduction in supply agreed to by OPEC and Russia early last week and slated to begin early next month. According to the organisation, its decision will reduce global oil supply by 9.7 million barrels per day (bpd).

However, some analysts fear that the reduced pumping rate is not nearly enough to compensate for the 25 percent slump in global demand which equates to roughly 20 million bpd. Moreover, in a barely noted addendum to the agreement, OPEC and Russia used an October 2018 baseline for their calculations. At that time, production volumes were some 3.5 million bpd higher than those reported in March. This implies that the cutbacks amount to only about 6 million bpd. Not only is the present oil glut here to stay, it will likely swell significantly over the coming months.

If investors can derive any guidance at all from the first concrete economic indicators to come out after the sudden start of the Corona Recession, it points to continued uncertainty and the absence of wider trends. The statistics and numbers are, in fact, almost meaningless. The laws that underpin the functioning of markets and economies seem to have been suspended as the almost surreal dimension of the crisis, and the equally unprecedented scale of the official response, become clear. The cliché of navigating unchartered waters gains a whole new meaning that is perhaps more menacing than anyone could have dared guess.