Gary Shilling Gary Shilling. (Photo via Gary Shilling)

Be prepared for U.S. stocks to breach their late March lows and drop 30%-40% as a “prolonged and deep recession” lasts into 2021, says economist and investment advisor Gary Shilling.

“We believe the prolonged recession will more than offset the monetary stimulus effects on stocks this time,” writes Shilling in his latest Insight report. “The bear market rally will reverse when investors no longer believe the government, especially the Fed, can support the economy in the face of the corona crisis.”

There are already signs that investors are becoming more cautious about U.S. stocks as COVID-19 spreads and some states, including Texas, California and Arizona, reversed some business reopenings. The S&P 500 ended a five-session winning streak on Tuesday after trading in a narrow range in June and at midday Wednesday was trading only slightly higher.

Coronavirus infections in the U.S. reached a new daily high on Tuesday, above 60,000, bringing the total number of infections to over 3 million with more than 131,000 deaths, according to Johns Hopkins University.

Shilling says several catalysts could reverse the gains in stocks: a second wave of the virus, which would force renewed lockdowns — the current spread is due to an expanded first wave; evidence that consumer spending and production isn’t picking up due to fears about the virus; or an end to expanded unemployment benefits — they are set to end on July 31, if no additional congressional action is taken.

Shilling likens the current stock market to the market in fall 1929 into the early 1930s, when a stock market crash in September to November was followed by a rebound that erased about half the earlier losses, only to be followed by the Great Depression, causing stocks to plummet again. They bottomed out in July 1932, down 89% from their September 1929 peak.

The S&P 500 this year fell 35% between Feb. 19 and March 23, followed by a rebound that erased about three-quarters of those losses. “Now the jump in infections in early-opening states and the likely unfolding of a long and deep recession will probably drive the stock market down by 30% to 40% from the current level,” writes Shilling.

Unlike the most optimistic economists and strategists who expect a V-shaped recovery or the more pessimistic ones who anticipate a U-shared or W-shaped one, Shilling is forecasting an L-shaped economy, characterized by stagnant growth.

Federal Reserve policies of near zero interest rates, massive asset purchase and multiple lending facilities to increase liquidity will not be sufficient to revive a weakening economy, says Shilling. “There’s much more Fed-created liquidity out there than consumers and businesses want, which suggests a weakening economy economy and falling stock prices in the future.”

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