Nearly 20 years after the last technology bubble, we’re in funny season again, and you don’t need to be an economics PhD to see it. Crazy valuations are being ascribed to stocks that have never made a dollar, in the hope they’ll become like Amazon one day. Think loss making stocks being priced on huge multiples of revenue implying that strong growth will continue for many many years in an otherwise low growth market. There is indeed a growing growth bubble in the ‘bubble in everything’.
Now undoubtedly the odd growth stock will be really successful for investors and will more than justify their current pricing by building a phenomenal business. (Hopefully some of these businesses will do more for society than make us addicted to consumerism and social media!) But importantly, many more growth stocks will fail to live up to their hype and eventually fall over.
For those focussed on risks - you know those of us who are old enough to remember the GFC and who want to avoid the next one, or indeed those needing to avoid the next one (think most investors, particularly those with large balances around retirement age) - there is also plenty of new as well as all too familiar downside risk to be concerned about.
As one simple example, it is a real worry when record numbers and the vast majority of IPOs coming to market are loss-making. Seemingly there is no need for profits – or even near-term profit expectations – and no substantial barrier to getting a US listing if you have a “good story” and high revenue growth. Is the world’s leading stock market turning into a funding vehicle for technology wannabes, hoping to emulate the success of previously hugely successful disruptors? So many of these companies appear to have little in the way of prospects for making the substantial profits that their massive market valuations imply. So, don’t be surprised if ‘Pets.com’ is coming to a listing near you, as the private equity crowds see the opportunity to take advantage of their ability to sell to irrational and exuberant public equity markets.
So, when is the growth party going to find itself against a brick wall and confront its unrealistic pricing expectations with the reality of inadequate underlying cash flows?
The markets seem to think not any time soon, given rates are expected to be low forever and besides, where else can you easily find growth. Indeed, many advisers are finding it very hard to see what is going to end this record period of outperformance of growth investing over value stocks. But here are some ideas about what could….
1. Investors may simply recognise that the valuation dispersion has gone too far; given we are at an extreme it doesn’t take much for gravity to exert an effect. The gap between value and growth valuations is now at record wide levels. One estimate concludes that 90% of fund managers are now growth orientated, which is possibly not far wrong given how difficult it has been to thrive or even survive as a value manager for years now. Value fund managers are being fired or redeemed from every week. When everyone moves to one side of the ship, one shouldn’t be surprised if the ship rolls over with no or only minor triggers of note.
2. Another trigger could simply be a reaction to a headline ‘growth stock’ failure e.g. Tesla going bankrupt, or Uber’s price collapsing post listing. This would challenge investor expectations that unprofitable growth investing into the hot stocks will scale into something beautiful, with the reality of going bankrupt, or a big surprising price collapse!
3. But of course, the big trigger – which would quite likely decimate growth investing - would be any change in inflationary expectations. Currently the consensus is convinced inflation is dead. So how could inflation surprise?
Well, governments may well need to ramp up their fiscal largess to keep the charade of economic growth alive. The adoption of Modern Monetary Theory or some variation thereof may well continue to gain policy traction with populist governments, potentially leading to higher inflationary expectations.
Indeed, monetary inflation has usually been the end result historically of unsustainable economic policy when governments control their own currencies. Will it be any different this time, notwithstanding the structural deflationary forces? Trillion-dollar deficits and underfunded US pensions are issues that are also growing by the day. Making a loss isn’t confined simply to your latest new hot technology stock! Which politician is going to tell their struggling electorate in the face of a crisis “No, sorry you all can’t have your pensions you’ve worked your whole life for. Even though we bailed out the bankers, we won’t bail you out”. Good luck with that. Instead, they’ll be inclined to say “Here’s the freshly printed money which your friendly central bank and treasury kindly simply created for us; we can just print the money we need to bail out your pension scheme.” What will treasury investors eventually think about all that largess when they realise all these shortfalls are going to be paid for – not through fiscal responsibility – but through massive new fiat currency issuance? Are they going to want to own low yielding long duration instruments when they can see the printing presses will go full monty?
Other political shocks or geopolitical disruptions to the oil markets supply and demand balance could also cause a meaningful change in inflationary expectations. Indeed, we are in an age where the risk of radical shifts in the status quo is under-appreciated or completely ignored because of a short term focus, widespread ignorance of the real challenges we face, and a blinked extrapolation of the status quo. For example, the risk of radical political and system changes necessary to meaningful respond to the massive threat of climate change should not be ignored.
4. The dominant buyer of US stocks might find themselves unable to continue buying should corporate debt issuance dry up. Amazingly, the main buyer of US stocks has been US companies themselves! Their buy-backs have been funded with debt issuance (other peoples’ money) and loose corporate debt markets while coinciding with insider selling, hardly inspiring confidence that company management has true conviction in what they are doing. Corporate debt markets – upon which these buybacks depend - are widely recognised as a major risk given the preponderance of lax lending. For example, investment grade debt markets are now dominated by the lowest tier of ratings, meaning large downgrades to junk status could see a wall of forced selling from investors.
5. Markets could, of course, do something that few think possible. They could simply collapse as major economies enter unanticipated recessions; recessions are routinely unexpected and anticipated by central banks and economists, although markets tend to start reacting ahead of recession. The last 2 market collapses in 2000 and 2008 saw equity market losses of more than 50% given the unsustainable situation they came from, with which today’s market environment has notable parallels. Such environments typically see high expectation stocks sold off even more as investors preference nearer term and more certain cash flow returns. Indeed, technology indices sold off 80% from 2000. For prudent investors, it is better to avoid excessive risks particularly when there are more conservative options to make respectable returns.
In summary, growth investors need to be prepared for the strong possibility of a big dose of reality. Growth investing won’t outperform forever. Government policy is going to find it increasingly difficult to keep juicing asset markets at the expense of their populations. Indeed, there are several triggers that could lead to a collapse in growth stocks, and plenty more that could lead to a collapse in the bubble in everything. If you’re interested in managing for risk, it is time to consider doing just that and managing the obvious risks in your portfolio. You might want to consider reducing your exposure to overpriced stocks, overpriced indices and ETFs, and overpriced interest rate sensitive assets. You might want to consider increasing your weighting to alternative and less crowded forms of risk including selective absolute return and dynamic asset allocation strategies, particularly those that can demonstrate an ability to provide good risk adjusted returns. These need to be diversified and not reliant on funny season continuing to thrive.
Let other investors stick with the crowd all the way until the next market collapse comes and then say “Fancy that, who would have known that even more debt can’t solve a debt problem, that economic policy was unsustainable despite trillion-dollar deficits and rampant pension underfunding even 10 years into a bull market, or indeed that companies actually eventually need to make profits – not just profitless growth - to see their investors make money!”
Investing doesn’t need to be a casino and you don’t need all your chips on black like so many portfolios are actually positioned right now! In fact, to protect and grow your wealth today, and to manage investor risks and goals over meaningful time horizons, you best ensure all your chips aren’t on black…
Jerome Lander is Managing Director of boutique investment firm Procapital, and an Authorised Representative of Harvest Lane Capital Pty Limited (AFSL No. 425334), which manages the Harvest Lane Absolute Return Fund. This communication is for informational purposes only and is a thought piece which represents the views of the author alone. It is not intended as an offer for the purchase or sale of any financial instrument. It does not constitute personal or formal advice of any kind and should not be relied upon as such – investors should consult their financial advisers before making any investment decision. This article’s accuracy cannot be assured. All opinions and views expressed constitute judgment as of the date of writing and may change at any time without notice and without obligation.
Thanks Jerome, Great article, couldn't agree more.
Well written and wise. Excellent advice.
Thank you for your generous comments Gents. Much appreciated.