Brave New World
September 23, 2020·2 comments·In Brief
The major stock indices are hitting new highs. Yet beneath those headlines, most stocks have been struggling since 2018. This gap between what indices show and what actually exists in the broader market reveals something uncomfortable about the foundation supporting current valuations. When a handful of companies drive all the returns, what happens when they stop?
• Market breadth is collapsing beneath headline indices. The S&P 500 and Nasdaq are lifted by fewer than a dozen mega-cap tech stocks, while regional banks are down 35-40% from their highs and small-cap stocks remain deeply underwater. When this many stocks underperform, market fragility is structural.
• Valuations rest on a foundation that was already cracking before the pandemic hit. Corporate earnings were flat in 2019, loan growth turned negative, and business credit was already tightening. The pandemic shock merely accelerated what was already beginning. This backdrop matters for how quickly earnings can rebound.
• The Fed Model justification for current multiples ignores basic financial reality. Large cap tech trades at 31x forward earnings, a multiple that assumes growth that mature technology companies simply don't have. Credit spreads suggest default rates of 3-4% when actual defaults are already running above 5%.
• Policy support masked the slowdown in real credit conditions. Tighter lending standards are already showing up in loan officer surveys. As PPP expires and federal aid runs out in October, layoff announcements from airlines, banks, and automakers suggest companies anticipated this was temporary. The recovery is slower than stimulus assumed.
• The contradiction is this: if the economy improves, tech valuations collapse. If it double-dips, they collapse anyway. Either way, the gap between what these stocks are priced at and what earnings support must close. The question is whether it closes through earnings or through price.
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This commentary is being provided to you as general information only and should not be taken as investment advice. The opinions expressed in these materials represent the personal views of the author(s). It is not investment research or a research recommendation, as it does not constitute substantive research or analysis. Any action that you take as a result of information contained in this document is ultimately your responsibility. Epsilon Theory will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. Consult your investment advisor before making any investment decisions. It must be noted, that no one can accurately predict the future of the market with certainty or guarantee future investment performance. Past performance is not a guarantee of future results.
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Comments
“It may be a brave new world, but it’s not enough to convince yours truly to start drinking the soma.”
I just reread Brave New World, The Sun Dial Press, New York, 1932 (First U.S. Edition). (I will assume the italics font above was a little gluey for ‘A …’ and ‘The…’.) I had not realized before that promiscuity was expected, especially for the alpha class. Both Bernard and The Savage struggle with this expectation whereas the lovely alpha-plus Lenina does not. (so perhaps not totally dystopic)
With an avalanche of USD both accomplished and impending, isn’t even risk-off now risk-on? The $64,000 question for me is how to diversify the so-called risk-off? I don’t want to kick the soma and end up with Kool-Aid. Cheers!
Thank you for the piece. Like Victor, it feels like there are a number of $64,000 questions out there. What if companies just issued stock for all the stock buybacks they completed over the past 5 to 10 years? Why should the government step in with loans and PPP? Passive flows (Green) where ~40% penetration has no thought about the price of a stock. Maybe we should have taken our medicine in 2008? Are we trapped?
Looking forward to future posts.
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