This guest commentary was written on 8/27/20 by Mike O'Rourke of JonesTrading.
Over the past 25 years, we have experienced the equity bubble of 1999-2000, the housing bubble of 2005 to 2007 and the concurrent credit bubble that financed the housing bubble.
Today we are witnessing an environment that eclipses each of those episodes - asset classes of all forms, equities, bonds, real estate are all in bubble territory. Experience has taught us that when people start to ask if you are in a bubble, you usually are.
It does not mean it will imminently pop, it simply means if you don’t get out soon, there will be significant pain ahead. An important ingredient in bubble formation is some fundamental positive that serves as a foundation for the “its different this time” thinking that allows for stretched valuations.
In 1999-2000, that fundamental positive was “the new economy” based upon the internet. It was going to change the world, and it did with the help of many of the key market leaders. Companies such as Microsoft, Qualcomm, Cisco, Intel and Amazon went on to achieve remarkable success.
That said, every one of these companies saw their share price decline 75% to 95% at some point over the next decade.
The warning signals about this market have been here for some time. The most popular space of equity issuances are blank check companies, renamed SPACs.
The most popular investing strategy in the world and the most crowded trade is to passively set it and forget it, making purchases with no thought to valuation or the environment. As long as companies exceed earnings forecasts, their shares are bid up significantly, never mind that earnings are down significantly.
It has been a record year for both equity and credit issuance, and all of this is amidst the worst global recession since the Great Depression, and with S&P 500 earnings forecast to decline 28% for the year. In short, we are witnessing massive multiple expansion from both earnings declining and share price appreciation.
The “fundamental positive” fueling these concurrent bubbles has been the Federal Reserve.
The Federal Reserve officially updated its Monetary Policy Framework today. The action essentially codifies the FOMC’s strategy if infinite zero interest rate policy and asset purchases until PCE Inflation rises meaningfully above 2% (something that these policies have been unsuccessful in doing over the past decade).
In a remarkable stroke of central banking irony, the institution that has created these bubbles cited the need for a stable financial system to achieve its goals.
The framework stated, “sustainably achieving maximum employment and price stability depends on a stable financial system. Therefore, the Committee's policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee's goals.” They appear to have chosen to create financial stability by being a perpetual stabilizing bid in the Treasury market.
Why are we primed to pop now? The valuation argument is an easy one, the S&P 500 is now hitting the 1999-2000 P/E multiple on a trailing basis (chart below).
On a forward basis, based upon Standard & Poor’s $113.47 forecast for 2020 earnings, the market is on pace to exceed the 1999-2000 peak multiple. Another measure is the S&P 500 market capitalization as a percentage of GDP, which has risen to a record 152%, eclipsing the 2000 peak of 121%. More importantly, from a timing perspective, the reckless speculation has become too blatant and too aggressive.
This has been clearly illustrated by market reaction to the announcement of stock splits by high fliers Apple and Tesla. Countless amounts of uninformed buyers have come into these names believing a stock split somehow creates more value.
In the span of four weeks, Apple, the largest company in the world, added $500 Billion in market capitalization.
That is equivalent to one Berkshire Hathaway, the 6th largest company in the S&P 500. Tesla shares have appreciated 68% in the span of a little more than two weeks for the same reason. At least Apple reported good earnings, whereas the only news in Tesla is the split. Tesla alone is now nearly 3x the size of the S&P 1500 Auto and Components index.
As we noted following Tesla’s announcement, our experience tells us stock splits are negative for share price performance. There was a time when they were viewed positively, because the lower price allowed more shareholders to purchase round lots.
Today, we live in an age of fractional share purchases, so that argument is no longer holds. Anyone who has wanted to buy shares of these companies has now done so, many for the wrong reasons.
The long term holders should be aware because now they have a tremendous number of bad buyers invested along side of them. Those new holders are arguably more dangerous for future investment returns (recall the 1999-2000 leaders) than the worst economic environment since the Great Depression.
The investor behavior in these two companies simply illustrates what is happening market wide, highlighting the equity bubble and the time to get out while one still can.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Mike O'Rourke, Chief Market Strategist of JonesTrading, where he advises institutional investors on market developments. He publishes "The Closing Print" on a daily basis in which his primary focus is identifying short term catalysts that drive daily trading activity while addressing how they fit into the “big picture.” This piece does not necessarily reflect the opinion of Hedgeye.
