Bubble, bubble, oil and trouble
Frothy pockets popping up but it's too early to cut back equity overweight.
One of several books on my list to write is titled “Forty Years, Forty Lessons: Investment Rules from a Career of Global Financial Bubbles and Collapses.” One would hope that I learned something, through both successes and failures of managing portfolios within nearly every financial market bubble and subsequent collapse spanning the early recovery from the great 1973-74 Bear Market and late 1970s’ stagflation through the 1980s’ Japanese Bubble, 1994’s Mexican Peso Crisis, the 1990s’ Southeast Asian Bubble and Crisis, 1998’s Long-Term Capital Management demise and bailout, late 1990s’ Tech Bubble and subsequent market collapse, the 2008-09 Great Recession and, most recently, the Covid Crisis.
I did manage to pick up a few pearls, including these: nearly all bubbles start with a good fundamental driver that is real; nearly all bull markets evidence pockets of bubble behavior within them; and nearly all bubbles last far longer than most expect. And here’s one more: central banks are almost always—not universally, but almost—involved in both creating the underlying conditions that lead first to economic health, then to bubbles and, eventually, to the bursting thereof. Which brings me to Jan. 28, 2021, as talk of a “stock market bubble” is very much in the air. And at Federated Hermes, very much has our attention.
The “Good Story” bubble
One bubble out there is in stocks with a good story, call it “potentially strong fundamentals.” Think many of the stocks in the alternative energy patch. Clearly, this sector of the economy is evolving quickly and is likely to be heavily supported by both governments and consumer demand for cleaner energy sources. That’s the “good story.” The difficulty for fundamental investors is that many of these stories are in their very early stages, with no near-term prospects of cash flows or even revenue, making them hard to price. Collectively, there will certainly be quite a few 100 baggers here (stocks that return $100 for every dollar invested), but my guess is that seven of 10 will go up in flames. Lots of homework needs to be done to improve the odds. Dangerously, many price momentum investors are jumping in on the back of the “story” only, with little conviction or understanding of the fundamentals, assuming that the price action alone is a signal that someone, somewhere, is doing the work.
This kind of investing is tricky business, and every now and then a big winner (say, Tesla) eventually emerges from the pack and produces outsized returns. Though many of these stocks are not our cup of tea, there’s some underlying positive that investors are trying to identify. Though many investors will eventually be burned, a few will in fact get rich buying these names. More importantly, these kinds of stocks remain, for now, at the fringes of the bulk of market activity, and in our view do not present a clear and present danger to the broader market that collectively holds many, many stocks with rapidly compounding cash flow, and/or bright cyclical prospects. As a whole, the S&P 500 is trading at about 18.5x our estimate of 2022 earnings, hardly a “bubble,” especially with 10-year Treasury bond yields hovering between 1-1.25%
The “Bad Story” bubble
Another “bubble” of late is the much publicized, but hardly new, momentum/technical strategy of buying heavily shorted stocks, often ones with the opposite of more classic momentum investing: stocks with poor fundamentals and tough “stories.” This game in my mind is even more dangerous than the first kind of bubble, and its present format as seen in the market this week (see Steven Chiavarone's short, below) is likely to end in tears on both sides of the trade—those shorting “weak fundamentals” stocks that have fallen, maybe even beyond what they deserved. This kind of shorting always gets dangerous the longer it goes on, especially as negative momentum traders jump in to grab a chunk of the dying wildebeest. Eventually, price action like this often attracts another group of investors who see the downside action as overdone and vulnerable to a classic short squeeze by taking the other side of the trade, going long. At the margin, both sets of players have lost touch with any fundamental anchor, and eventually someone, sometimes everyone, gets burned. This is what is happening this week on a large scale with GameStop.
Again, though, this kind of “quick profit/quick loss” opportunity is present only in remote corners of the market, and therefore unlikely to spread to the bulk of the market. And eventually, the game ends with both sides in a heavy loss. This said, there’s certainly potential for further collateral damage as levered books get unwound; if and when that happens, it could present a rare buying opportunity in the broader market. We’ll see.
Oil and trouble?
A more legitimate longer-term risk for the markets, we think, is the coming commodities cycle alongside the likely synchronized global recovery ahead, and its potential to impact broader inflation rates strongly enough to cause the Fed to blink. Readers of this space know that a key driver in our view of the next big leg up in stocks is likely to be the very unusually synchronized global economic recovery later this year as the Covid vaccine gets broadly distributed worldwide and causes animal spirits everywhere to rise, almost at once. We think this economic up-cycle will most improve prospects for the so-called “value” stocks—companies operationally tied to the broader economy such as industrials, materials, financials and computer chips. Given the underinvestment, and rationalization, in these economic sectors over the last decade, short and even intermediate term supply shortages are likely to arise (some already have in the recovering housing sector), pressuring commodity prices higher. And if unemployed gig workers get re-engaged quickly as the cycle accelerates, wage inflation could be next.
This is the Fed’s hope, so our guess is early on it’s likely to applaud and respond passively; witness Chair Powell’s “What bubble?” news conference earlier this week. At some point, though, the Fed blinks, and if that happens at the same time that the broader market is more extended than it presently is and the global cycle starts to peak out, a significant stock market correction could ensue for sure. But given our present circumstances, it seems we are at least a year or two from this point, and who knows if we’ll ever get there. For now, we see real trouble as a long way off.
Masses of individual investors on social media have been fueling explosive share price increases of video game retailer GameStop and other companies that were being heavily shorted by Wall Street. Essentially, this group of online traders have gone beyond disagreeing with short sellers by taking them on. At the center of this back-and-forth is short selling, a strategy in which investors borrow shares of a stock at a certain price, sell them and buy them back later to fulfill their agreement to return the shares to the lender. Their bet is the stock will fall in price in the interim, earning them the difference between the price at which they sold the stock and the price at which they bought it back. However, if the share price moves higher after it is borrowed and sold, the short seller will have to buy the shares back at the higher price, losing the difference between the price at which they sold and the new higher price. In the case of GameStop, chatter on online trading forums generated massive interest in buying the stock, pushing up the price, which in turn fueled even more interest. Access to the options market enabled these investors to use leverage to further push up the price. This high level of trading created what’s known as a “short squeeze,’’ in which Wall Street short sellers were forced to act fast in order to limit their losses, steps that effectively pushed the price even higher. — Steven Chiavarone, portfolio manager and equity strategist