Key points

1) The May jobs “shocker” was largely a reflection of CARES coverage of corporate payrolls.

2) The gap between Wall Street and Main Street appears similar to the “incubation phase” of other major downturns.

3) Federal support remains essential, but is best targeted toward preserving the “circular flow” of the economy by supporting the basic incomes of families and incentives for productive investment, limited to those actually experiencing economic damage.

4) After years of overborrowing to finance stock repurchases (partly to offset dilution from stock-based compensation), many corporations were overleveraged coming into this crisis. Bankruptcies are likely to increase, but the government can support packaged restructurings and bank purchase-and-assumption transactions without bailing out private investors, who agree to accept these risks in a free-enterprise system.

5) Fed purchases of uncollateralized corporate bonds violate FRA 13(3), CARES 4003©(3)(B), and potentially Article 1 Section 8 of the U.S. Constitution.

6) Projects that are enabled only by zero interest rates are most likely projects that are speculative and unproductive.

7) Improved market internals currently encourage an agnostic near-term outlook (though not a bullish one) despite several features that suggest the improvement is fragile.

8) Valuations are again near historic extremes.

9) Continued dispersion within the U.S. equity market suggests particular risk for richly valued large-cap stocks.

Incubation phase

On Friday June 5, the Bureau of Labor Statistics reported that U.S. nonfarm payrolls jumped by 2.5 million in May, following a (downwardly revised) loss of 19.7 million jobs in April, sending Wall Street on a full-tilt, dubstep remix of “Happy days are here again.” It was a fitting choice, given that the song was written in 1929. Of course, the Great Depression also began with a spectacular financial rebound that bore no relationship to the underlying deterioration on Main Street.

Severe economic recessions often feature what might be called an “incubation phase,” where an exuberant rebound from initial stock market losses becomes detached from the quiet underlying deterioration of economic fundamentals and corporate balance sheets. From the post-crash low of November 13, 1929, the Dow Jones Industrial Average enjoyed a 48% rebound, peaking on April 17, 1930, followed by an 86% collapse by July 8, 1932 (an overall loss of 89% from the September 3, 1929 bull market peak).