The new valuation equation.
Fundamental drivers for pricing valuations in public markets have changed. Now, there is a new interaction among factors unseen just recently. Advanced technologies such as artificial intelligence have had a profound impact on the tools available and analysis presented to even the most amateurish investor. Social media, such as Reddit, Twitter, and other platforms, have allowed access to information and influence from media “stars” driving demand in an almost herd-like mentality driving up prices, and causing extreme volatility. Finally, technology has enabled a trading floor to be in everyone’s pocket. That same trading floor allows access to any information on anything from anywhere, and communication with anyone or, via social media, receive communication and information (regardless of how dubious) from anyone about any security or investment strategy.
These factors will cause unprecedented market volatility, along with extreme price movements for well-known (or perhaps more accurately, well-publicized) companies and their securities. While the supply of securities remains somewhat constant, demand for those securities is increasing (sometimes exponentially) because many more investors are now chasing those same securities.
The price of anything cannot escape supply and demand dynamics. Recent IPO activity is an attempt to meet growing demand (and raise capital at attractive prices). The new supply from IPO’s, secondary stock issuances, and most recently and monumentally, SPAC offerings, still do not provide enough supply to quench a growing and overwhelming demand. The valuations, especially those given to the SPAC’s, are entering stratospheric levels that could hardly be justified under normal market conditions.
Who Said Normal?
But these are not normal market conditions, and the genie is out of the bottle. These conditions will also not be without volatility and fickleness. In the same way that a herd charges in one direction, it can reverse the charge in the other quickly and without much warning. Demand generated by advanced technologies and social media can defy economics, but it disengages quickly. As John Maynard Keynes speculated, “what’s the price of a security when no one wants to buy?” The answer is extreme price drops driven by this investor base, not just price run-ups.
It almost seems too easy to predict, but we have seen this so many times throughout history, whether it is tulip bulbs in Amsterdam (fooling Isaac Newton into taking profits but then reinvesting and losing everything in that bubble) because the market kept going up – what could go wrong? The Southsea bubble; US and UK railroads; the “nifty 50” (50 stocks that anyone could buy in the early 1970s that would only go up in value) which ended disastrously with more than 80% in total value lost by these “can’t lose” stocks, to the Dot.com era companies that were absurdly valued even though they had little to no prospect of ever generating profits.
Many of today’s companies fit the same combined profile
- values are still going up, so what can go wrong?
- innovation and growth are more than important than profits. So who cares if they are ever profitable?
- An innovative business model is its own reward.
A lot can and will go wrong.
A frenzy is a frenzy and irrationality has not changed nor will it cause a different outcome this time. Typically, companies that are considered “nifty 50” can rarely sustain themselves. Take the most valuable companies across any 20-year time period and the turnover is astonishing. Almost every “can’t miss” company misses. Picking the portfolio and believing these are the companies that will define the future and create the most value is laughably naïve. Yet, it’s a story that gets repeated constantly to every new generation of investors, as it is today, and it will end in tears.
Disruption is one thing, profitability is another. Many pricing models of innovative companies end up being nothing more than a race to the bottom. Valuations reaching 5x to 10x revenue five years from now can be justified by perhaps 1 out of 1000 companies. In this market, it is almost every other new issue. Reversion to the mean is inevitable – that number of companies simply cannot be that successful. The global economy is just not that big. The average company cannot trade for 30 times its earnings sustainably. There are exceptions and exceptional companies – just not all of them.
Now That the Pandemic Is Almost Over, Everything Goes Back to Normal
While we would love nothing more than to click our heels and have global markets, trade, geopolitics, and health go back to some more sanguine time, that is not going to happen. We have short memories, and many things will go back to normal activity (remember restaurants and movie theaters?), but some meta-trends have been sparked, magnified, and are irreversible.
Certainly, we’d like to forget the worst global pandemic in over a century that magnified political bumbling, partisanship, irrationality, and an inescapable feeling that the world is in the hands of fools. The fundamental trajectory for many changes has also been magnified.
- Central bank policy is playing an unprecedented role in our lives today and for the foreseeable future (“from now on” seems hyperbolic – although I don’t see when this can end).
- Unemployment is recovering and production is challenged to keep up with newly sparked demand (inflation anyone?).
- The Federal Reserve is doing its best to keep interest rates low while battling the prospect of new inflation.
- Despite their efforts, the 10-year Treasury is rising
- Even with federal funds rates at zero, bond prices seem to be rising – although the average yield on high-yield bonds is still only around 4.0%.
Hardly ushering in an era of pricey capital, stagnation, and out-of-control inflation.
Thank You, Fed
A health emergency and an ailing economy should have cratered financial markets. But, an extraordinarily generous capital market can only be explained by the Fed’s and the US Treasury’s aggressive actions. Can this be sustained? Beginning in March 2020, panic selling ended up being limited to March. Investors believed in an inevitable economic recovery. Optimism around pandemic treatment and recovery, near-zero Fed Funds rates, and apparent ignorance of risk along with a tolerance for much greater volatility caused asset prices to keep rising, and exceptional buying opportunities were short-lived. Valuations are high, but optimism still reigns over the markets.
Investors seem to have a clear vision of the future and are optimistic (after all, many technology-based companies are trading at 5 to 10 times revenues 3 to 5 years from now – that pretty much defines optimism), but reality will turn some of that optimism illusory. Only a major deviation from an expected trend can generate highly attractive investments. But identifying these is a rare talent. Most macro forecasts (and most forecasters in general) are wrong most of the time. Basing investment decisions on macro forecasts is a fool’s journey. Social media makes forecasts louder and more pervasive, but not any more accurate.
Don’t Predict, Prepare and Withstand
Beginning in 2020, there was a lot of confidence and clarity about the economy and the stock market. With the arrival of the pandemic – an exogenous shock for sure – it was once again proven that we never know what’s going to happen.
Today’s environment shows that we have a lack of clarity with many divergent opinions regarding economic and market outlooks. While we seem to have a healthy economy, and the Fed is telling us it plans years of accommodative monetary policy, consumer spending is rising above average, and pent-up demand, according to Harvard economist Jason Furman, represents approximately $1.8 trillion of extra expenditure to be unleashed post-pandemic.
Asymmetry Goes Both Ways
However, asset prices already seem to reflect this full recovery. Combined with increasing interest rates, asset prices seem to be at risk for significant declines as interest rates rise (cash flows discounted at higher interest rates decrease present values). Interest rates can rise from here, but they really can’t decline. Since we are essentially at zero from the Fed, and the Fed has made it very clear that it will not engage in negative interest rates, there is a negatively asymmetrical potential for valuations. The price of 10-year Treasury notes has risen from approximately 0.52% in August 2020 to 1.64% in March 2021.
A couple of very important questions arise when it comes to interest rates and valuations.
- Can the Fed keep interest rates artificially low from now on?
- What about longer maturity bonds?
- If inflation rises, can the 10-year Treasury note still yield 1.64% if inflation reaches 3.0%?
Currently, despite these concerns, investors are acting as if we have a low-interest-rate environment from now on. What that means is that higher risks are being tolerated to earn higher returns.
Social Media is the New Normal
Retail investors have poured into speculative securities and “meme” stocks with heavy buying of not only stocks, but options, and increasing margin on purchases. Many IPOs, including many unprofitable companies, are seeing price jumps and enormous gains in the short-term.Optimism is one thing; complacency is quite another. We have had a strong performance with speculative securities, and the herds keep piling in, led by the siren songs from Reddit, Twitter, and elsewhere.
Value may be what you get, but price is what you pay. Price is determined by supply and demand, and the dynamic now in the market is overwhelming demand with limited increases in supply. SPAC’s are an example of supply generation to meet this overwhelming demand, especially for “disruptive” companies in emerging technologies. It is indisputable that these are overvalued when looking at even the most basic growth and profitability metrics. But that’s the “value;” the prices are determined by supply and demand dynamics – and the overwhelming demand will keep prices up even as this relative trickle of supply increases available securities.
Slowly, Then Suddenly – But Only for Few
But, as we’ve seen if demand is driving price, prices stay steady – until they don’t. Once securities’ prices start to drop as demand wavers, the social media-driven buyer base disappears, and prices will plummet for many of these speculative public securities.
While there will be a correction in speculative stocks and rapidly growing technology companies (regardless of the quality of their business model), valuations will decrease, and impact the overall market, driving market indexes down overall. But a big correction to the overall market looks remote. There is still positive investor sentiment even if speculative stocks blow up.
Uncertain for Some but Okay for Many
We are facing an uncertain world with the prospect of overall low returns because interest rates are at extremely low levels, asset prices are high and most are fully priced, people are engaging in riskier and riskier investment strategies searching for yield as well as finding the “next Amazon.”
Overall, the economic cycle still looks positive and we are probably in for continued overall economic growth.
- The economic outlook is positive and interest rates will stay low for years
- Monetary policy is extremely accommodative
- Fiscal policy has never been more generous (pandemic stimulus packages are more than three times greater than the overall stimulus packages from the 2008 to 2009 financial crisis)
- Inflation has stayed relatively low, but its prospect is uncertain
- There is euphoria and risky behavior, especially among certain stocks touted in social media and driven by advanced technologies that few understand but many are willing to invest in, nonetheless.
- Valuations are high, and a large degree of that value comes from a low interest-rate environment, which may change. Risk is not being compensated, and risk premiums are narrowing further.
About Those Fools
Government poses a risk because it is becoming increasingly obvious that anti-capitalist sentiment and policies are being espoused with greater, and alarming, regularity. Hopefully, reasonable majorities will render radical legislation less likely.
As we have seen, fundamental economics – interest rates, economic growth, risk premium, etc. are now only a component driving some of the extreme edges of the markets. But those extreme edges are generating significant and volatile demand that will impact overall markets and valuations for many securities.
Advanced technologies have put the trading floor in everyone’s pocket, along with the ability to access any information from anywhere (whether legitimate or not) and connect to anyone with an opinion. Unfortunately, the loudness of that opinion is typically in an inverse relationship to the quality of the information provided. A powerful new tool will magnify volatility and increase market participation substantially from now on. Whatever direction markets will go, it will go there faster and more intensely.
Finally, social media connects many people to useful, interesting, and valid research and knowledge. This is a very positive development and used responsibly can lead to more reasonableness and thoughtfulness. However, users of social media are hardly evenly distributed, and the ship of fools has become a titanic, people with vested interests in market valuations and outcomes are shouting the loudest and drowning out anyone who notices there is an iceberg dead ahead.
It’s Risk-Adjusted Return
Alpha still exists, but it’s meaningless without understanding risk.
While there is plenty of capital, most assets seem fully priced with an under-estimation of risk. There are alternative investments where higher returns without the same commensurate increase in risk are available. Some return is simply mispricing of securities through lack of attention (those starved from social media can create meaningful opportunities for those savvy enough to look for them) or liquidity.
Successful investors are the ones who understand adding return without corresponding risk is the most important component of successful investing, especially given the new equation for valuation:
Economics + Advanced Technologies + Social Media = Price
These three components are now inexorably linked and constitute an influential role in determining valuation from now on.
The More Things Change…
The pandemic has challenged many preconceived notions about the economy, markets, and public policy – and has impacted the way we live. But the inescapable truth remains unchanged:
There is no magic answer. No solution other than superior skill enables an investor to earn a high return safely and dependably. That is even more true in today’s low-interest rate, low return Tower of Babel world.