Reddit and Weep?

03.31.2021 - Douglas Cohen, Portfolio Manager

Even with the recent modest correction in some “risk-on” assets, many investors believe that bubble-like conditions persist among Reddit-inspired meme stocks, cryptocurrencies, special purpose acquisition companies (SPACs) and many early-stage companies in potential high-growth industries.  When Dogecoin, a literal joke of a cryptocurrency with a dog’s face on it, reaches a $10 billion valuation, in our opinion, the market’s animal spirits have probably run too far.

What Have Bubbles Looked Like in the Past?

The history of financial market bubbles has been that they typically grow far larger and last longer than many skeptics anticipate.  Until last week, the 100 largest stocks in the Russell Microcap Index were up almost 87% in 2021 after roughly tripling last year.[1]  However, can any or all of those ongoing bubbles burst without taking the equity market, and even the broad economy down, with them?  Indeed, that is exactly what happened after the tech sector imploded in 2000. So much paper wealth evaporated as part of the Nasdaq’s approximately 80% peak-to-trough decline that it triggered both a near-50% plunge in the S&P 500 and a recession.  

Are We Nearing a Bubble Today?

The good news is we don’t believe we are on the precipice of near-term disaster. A 10% or so broad equity correction seems overdue—indeed, the Nasdaq recently breached that threshold—and we would view that as an admittedly euphemistic “healthy” correction given how the market’s large-cap growth stocks have performed over the past 10 months.

Regardless, unlike arguably the most disruptive financial crises in history in 2008, the current areas of apparent speculation don’t appear to be highly leveraged. Companies with debt-laden balance sheets typically are forced to dramatically reduce spending when their bubbles burst.  In actuality, the large majority of the recent market leaders (the fabled FAANGs+) have exceptionally strong balance sheets.[2] In fact, the 50 largest stocks currently trade at about 23x one-year forward earnings, well below the comparable 31x multiple seen in March 2000 at the height of the Dotcom Bubble.[3] Again, that lower multiple comes with stronger balance sheets and lower interest rates.

So, What’s the Bad News?

The not-so-good news is that, even if the major equity indices and broader economy appear on more-than-solid ground, there is still much that could go wrong. Since the Great Financial Crisis, the Fed has taken aggressive action when markets have threatened to become disorderly. Legitimate issues such as wealth inequality and the “punishment” of savers aside, their policies have generally worked.  The challenge going forward is that there is not much more they can do in terms of conventional downward rate adjustments if they stay true to their stated desire to avoid negative interest rates. Such levels have seemingly done little to revive the European and Japanese economies.

Sustained low interest rates may well have also created some unintended potential consequences down the road if the economy comes roaring back.  Should inflation spike higher, the prevailing market psychology would likely be dramatically altered, and fears of Fed rate hikes could weigh heavily on today’s equity valuations. There is a chance that the Fed might feel compelled to implement more unconventional measures such as yield curve control that could introduce a new set of risks.

Tipping Points and Zombies

While most S&P 500 balance sheets today appear to be strong in terms of near-term debt service ratios, some weaker companies survived early 2020 (and 2008) by largely taking on more debt. That tactic can likely be sustained if rates stay low, but any sizable uptick would probably make refinancing very challenging. A tipping point for equities in recent years has been a 3% yield for the 10-year US Treasury. The US has rarely had much tolerance for the “zombie” companies (meaning those earning just enough money to continue operating and servicing debt but unable to pay off debt) that contributed to Japan’s so-called lost decades. However, the economic consequences from waves of bankruptcies if rates do spike higher could be severe.  

How Much Does a Printing Press Cost?

The COVID-19 crisis may have ushered in a new era of government willingness to bail out broad swathes of the economy, given Washington’s perceived ability to print unlimited amounts of money. The Modern Monetary Theory[4] mindset has increasingly taken root among politicians in both parties, with the Tea Party movement and its fiscally conservative ways having faded from news headlines. We don’t think a printing press can solve our economic challenges without serious unintended consequences.  Our fears are not assuaged when some market commentators suggest that interest rates can’t go up because the country simply can’t afford for them to go up. To the extent that financial market history continues to at least rhyme if not repeat, reversion to the mean is still a remarkably time-tested phenomenon.  Interest rates very likely will rise significantly over time, just as most of the Reddit-inspired stocks that have recently experienced exponential increases will likely revert toward their true (much lower) values. 

A Look Ahead

To paraphrase Scarlett O’Hara, we think the concerns highlighted above are generally things to worry about another day. But the market remains a discounting mechanism. Today’s generally lofty valuations likely incorporate a fair amount of the global economic reopening likely to occur over the next six to 12 months, aided by broad vaccine distribution and sustained high levels of fiscal and monetary stimulus. Powerful earnings growth may compensate for the seemingly inevitable multiple compression to come. We continue to believe that, in the near-term, the momentum is more favorable for cyclically oriented stocks than the growth darlings that dominated during the “Goldilocks” days of roughly 2% economic growth. The reopening-oriented companies generally cut costs aggressively during the worst of the COVID-era and thus should have strong operating leverage[5] over the next several quarters as GDP growth looks to move higher. Even with the aforementioned possibility of a healthy correction, we believe that equity markets are poised to end the year comfortably in the black. 

[1] Source: FactSet. The 100 largest current constituents returned a weighted average of 233.9% for the year ending 12/31/2020 (which equates to approximately a tripling of valuations) based on current weights. Those same companies returned a weighted average of 86.6% from 12/31/2020 to 3/5/2021 using the same weightings.

[2] FAANGs+ represents Facebook, Apple, Amazon, Netflix, Google and Microsoft.

[3] Source: Barron’s, “Today’s Stock Mania Differs From 1999’s, but That Might Not Matter”, Forsyth, Randall W.; 2/13/2021.

[4] Modern Monetary Theory suggests that governments like the US do not rely on taxes or borrowing for spending since they can print as much as they need and are monopoly issuers of the currency. According to the theory, their budgets are unique and should not be shaped by fears of rising national debt.

[5] Operating leverage is a cost-accounting formula that measures the degree to which a company can increase operating income by increasing revenue. A company that generates sales with a high gross margin and low variable costs has high operating leverage.

This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.


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