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Are The Equity Markets Over Optimistic?

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The global economy has been put into a medically induced coma. The pandemic has forced economies around the world to pause, sending them into an unexpected downturn.

Unemployment figures in the US have spiked at a record pace, with more than 26 million unemployment claims in the past 5 weeks. At this rate, the US will hit 25% unemployment by the summer, reaching Great Depression levels. Despite the alarming headlines, the S&P 500 has rallied over 25% from its lows 1 month ago and is now down less than 13% year-to-date.

The market has been increasingly optimistic following the Federal Reserve’s unlimited QE proposal, and the fiscal stimulus provided by the CARES act that promises to keep Main Street alive. But will this be enough? Cleary, the Paycheck Protection Program (PPP), specified in the CARES act, is not keeping people employed, and the government cannot fund our economy forever.

Why The Market Is Over Optimistic

The market is too optimistic about the economic outlook and timeline for recovery. The biggest issue that I see for this economy rapidly recovering is the lack of vaccines or even treatment. One of the more promising treatments, Gilead’s (GILD - Free Report) remdesivir, flopped in clinical trials this week, and a vaccine is more than a year out.  

Without either antibodies or a vaccine, people are still at risk of getting infected, and social distancing will need to remain in place. This means that restaurants, bars, and retail stores will have to significantly limit capacity (depending on government mandates). Local businesses rely on monthly cash-flows to remain afloat, and when you restrict capacity, you will inhibit these cash-flows, which will weigh heavily on Main Street.

Georgia and South Carolina are the first states taking steps to reopen their economies. Georgia is opening hair salons & bowling alleys this week and restaurants & theaters next week. South Carolina is allowing retail to resume but with the limit of one customer per 1,000 square feet (roughly 20% capacity).

These states represent a trial-run for a slow reopen without accelerating the spread of COVID-19. If these states prove unsuccessful at controlling the disease while opening optimism will fade and the markets will break.

The US already has over 900K confirmed cases and more than 51K deaths. At our current trajectory, we will hit 1 million confirmed COVID cases by next week. The new case count in the US does not appear to be slowing.

When the US does finally control the virus, it will take time for many businesses to resume normal functionality, if they are able to at all. The tens of millions that are out of work will not immediately be reemployed. It will take years to get our unemployment back to where it was in February, and that means that demand will not reach its full potential for years.

What I Am Doing

I am hoarding cash right now and hedging some risk. The best way to hedge your equity risk right is by selling cover-calls. 

As the VIX (fear index) falls, it is becoming more lucrative to hedge some of my downside risk with puts. I have been buying SPY (SPY - Free Report) puts with expirations that are 1-3 months out, to hedge some short-term risk when the S&P 500 reaches specific levels.

I believe that a wave of bankruptcies is about to hit the markets and put the gravity of our current situation into perspective. I am waiting for a pullback in the S&P 500 to the 2,650 level (a level I plotted with Fibonacci retracement), in which I will start buying again. I think the Feds unprecedented unlimited QE has backstopped the market enough that we will likely not retest our lows, but I expect to see another leg down. Below is what I will be buying on the pullback.

My Shopping List:

Alibaba (BABA - Free Report)

Microsoft (MSFT - Free Report)

Adobe (ADBE - Free Report)

Facebook (FB - Free Report)

Lockheed Martin (LMT - Free Report)

Twilio (TWLO - Free Report)

Sea Limited (SE - Free Report)

Take Away

Don’t chase this rally. The markets are trading at a premium, with risk and uncertainty being exceedingly high. 

We have no idea how long this virus will haunt our economy. We have no idea how extensive unemployment will become or how many years it will take to reach full employment again. We don’t know how much our GDP will fall this year or how it will look in 2021.

When screening for stocks, look for high-quality tech names with healthy balance sheets and compelling product offering that will remain a necessity in all economic climates. Technology is getting us through this pandemic, and I am confident that tech will drive our post-pandemic economy.

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Zacks has just released a Special Report that spotlights this fast-emerging phenomenon and 6 tickers for taking advantage of it. If you don't buy now, you may kick yourself in 2020.

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