Amygdalotomy and Extremes Everywhere

May 26, 2020

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The chart below shows the S&P 500 rally since March 23. This has coincided with:  
1. A deep worldwide recession, 
2. Continued US earnings decline over the last 18 months,
3  Forward expected earnings falling back down to 2017 levels, 
As a result of this divergence, the S&P 500 has violently broken its relationship with earnings. The 20 year correlation of 0.9 between the S&P 500 and earnings now simply has a minus sign on it -0.9!
Either economic expectations of a V shaped recovery will be proved right, or the Fed’s astonishing actions are destroying price discovery, as the Fed’s distortions go to new extremes to support equity prices with liquidity which seems to never repair an ever growing solvency crisis. It is worth noting that the US economy and core profits growth have remained weak despite all the interventions of the last 12 years, as shown in previous notes.
While Wall Street may be celebrating the rally, unemployment, which is already at the highest levels in decades, continues to rise. Beyond Wall Street there is little sign of improvement.

In my view, by aggressively intervening in the financial markets, at valuation levels that are still nowhere near run-of-the-mill historical norms, the Federal Reserve has performed an amygdalotomy on the investing public. The Fed has encouraged a maladaptive confidence that risk does not exist. This overconfidence of investors is itself a threat to their survival.
John Hussman
As Hussman also points out, fiscal policy has been no less aggressive. It is worth noting that the last time fiscal deficits were used this aggressively compared with a narrow output gap, CPI inflation accelerated. 
Notice that there are a few periods when the U.S. economy was operating near full capacity (blue line near or above zero on the left scale), yet government deficits were significant and even expanding (red line well below zero on the right scale). These differences are circled in yellow. The notable feature of all of the prior instances is that they were exactly the points when the inflation rates accelerated. Even in 2019, the government deficit spending was already significantly out-of-line with the position of the U.S. economy.

This increases the risks that even if the current round of interventions is successful, the next issue will likely be rising inflation. 
Here is a great discussion on these issues from last week, between a Fed insider, Danielle Dimartino Booth and Keith McCullough.
It is worth trying to get a sense of where these policies have already taken US equities. Do investors really believe these trends, shown below, can continue without better evidence these policies work in terms of durable economic and earnings growth?
Investors need very clear and effective risk management in this environment. This a market of significant distortions and ever more extreme policy measures which so far have delivered record equity valuations, but very little else.

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