The Theory of Sinkhole Economics

April 21, 2020

My Dear Reader,

Typically a booming stock market is the result of profitable companies reaping the benefits of a laissez-faire economic policy and a relatively stable domestic and international time period. However, that appears to have shifted to some degree in recent years, and I believe this health crisis has only accentuated that fact.  For now, I’m dubbing it “sinkhole economics” because like a sinkhole, the topsoil looks normal, but underneath is a whole lot of turmoil and loose dirt.  

In a recent article, sovereign man investing pointed out the fact that the recent oil price drop will affect more than just the oil market 

“Retail stores have been totally vanquished, and the bankruptcies are piling up; this could impact millions of workers in the retail sector and trigger a wave of defaults against the banks who loaned money to retail giants. And you probably saw yesterday that the price of WTI crude oil crashed BELOW $0. We’ll talk about that more in another letter… but it’s fair to say that low oil prices will force a lot of oil companies out of business. And that will impact workers in the sector who stand to become unemployed… and, yes, the banks who loaned money to oil companies. [According to a recent report from investment firm KBW, some banks, like Oklahoma-based BOK Financial, have more than 100% of bank equity tied up in loans to oil companies!] I’ve been writing about this theme since the pandemic started: there will be some banks that don’t make it. They simply won’t be able to withstand the loan losses.”

And yet the stock market has been relatively stable throughout this pandemic, which has helped quell the panic that can cause a bank run, but can also lure long term investors into a potential trap. In February of 2020, CNBC contributor Michael Sheetz made this point:

“Tesla, Virgin Galactic and even hydrogen engine maker Plug Power have all seen astronomical gains since the beginning of the year, with each of the stocks essentially doubling or even tripling. Each of the stocks fall firmly in the speculative category, with investors valuing the companies on what it could earn in the future – not what it does now. Most of the big moves are happening without any major news.”

Again, this doesn’t necessarily mean that all investing or market products are bad, but long term-investing could be significantly damaged because of the long-term exposure to risk and extra volatility that comes with the stock itself.  Furthermore, it’s clear to me that many companies have leveraged themselves into unforgivable positions that could leave banks holding the bag.

To your creation and potential,

Kevin Prendiville