BIG PICTURE

Coronavirus fears may be in the headlines, but corporate profitability was already on the wane.

Betting on an aging bull market running on shaky legs while wearing a medical mask is never a good idea. But the desire to make money will always convince some investors to ignore risk. That’s what happened in mid-February as China was attempting to contain COVID-19 with a coercive quarantine on almost 400 million panic-stricken citizens. At the time, you didn’t have to be a World Health Organization pandemic expert to know that the deadly virus outbreak and its impact on the world’s second-largest economy was being downplayed by local authorities. But with central banks back in fire-fighting mode, stock markets continued to soar. “Virus news continues to erupt worldwide and financial markets seem divided, with bonds saying lower interest rates for longer, slower global growth, and a downward inflation outlook,” Cumberland Advisors chief investment officer David Kotok noted. “Stock markets, on the other hand, like the low interest rates more than they fear the virus.”

Trusting central banks to save the day, of course, became harder as the virus spread worldwide. As February turned into March, global equity markets experienced the worst bout of panic selling since the 2008 financial crisis, evaporating trillions of dollars in paper wealth. The unexpected carnage moved some market watchers (and not just the ones working for U.S. President Donald Trump) to insist that COVID-19 will be remembered by investors as an economic hiccup that generated the mother of all buying opportunities.

But Dr. Doom — a.k.a. Nouriel Roubini, the economist who famously predicted the 2008 financial crisis— thinks this camp is delusional. In an interview with Der Spiegel, he argued the current shock to China’s economy will probably lead to a prolonged global recession, not to mention another financial crisis in the world’s largest economy, “because debt levels have gone up and the U.S. housing market is experiencing a bubble just like in 2007. It hasn’t been a time bomb so far because we have been experiencing growth.”

Whatever happens, bargain hunters should remember that U.S. equity markets were experiencing an outbreak of irrational enthusiasm long before COVID-19 became headline news. Also keep in mind the U.S. Federal Reserve cut interest rates three times last year, and again in March, leaving little room to stimulate the economy further. Growth in this cycle has been driven by consumer spending, which started showing signs of weakness prior to the virus panic. Furthermore, as Morgan Stanley chief global strategist Ruchir Sharma noted before the market turmoil, U.S. stock market valuations had reached a point where they accounted for more than 50% of the world’s market value, but were based on only 25% of global economic output.

Meanwhile, the latest corporate earnings statements are as trustworthy as Chinese epidemic reports. Profit margins in the U.S. have been declining for years, which is why business investment is so weak. But this weakness has been obscured by corporate income tax cuts and ongoing accounting games. Ed Clissold, chief U.S. strategist at Ned Davis Research, warned last September — when the gap between profits based upon generally accepted accounting principles (GAAP) and reported operating earnings became the eighth widest on record — that companies “are pulling levers up and down the income statement to sustain earnings growth.” And don’t forget the corporate share repurchases behind attractive growth in earnings-per-share numbers have largely been financed by debt.

Long term? Trump administration spending before any new economic stimulus or health emergency financing already had the U.S. budget deficit on track to break US$1 trillion in 2020, while day-to-day federal budgets for dealing with zoonotic threats such as COVID-19 were being cut dramatically. Feeling a little ill yet?