Investors have lost their minds when it comes to high-flying stocks such as Tesla (TSLA, up 830% over 13 months), Shopify (SHOP, up 210% over 4 months), DataDog (DDOG, up 220% since the March lows), and many other names where valuations are based on anything but the fundamentals. Why?
There Is No Alternative (TINA): The reality is that there is always an alternative. It is a mistake to believe institutional investors can’t shift investment allocations from public equities to fixed income, private equity, venture capital, real estate or some other asset class. It is difficult to find yield/returns but certainly not impossible. We happen to believe that private equity will be the primary winner as markets remain volatile for the duration of this year and 2021.
Zero Interest Rate Policy (ZIRP): Yes, low interest rate environments boost equity valuations relative to fixed income but to what end? Low interest rates don’t justify most valuations that we would consider overly expensive.
The future trade and the weakening consumer: As John Huston’s Chinatown character Noah Cross responded when Jack Nicholson’s detective Gittes asked him: “why do you do it, how much is enough?” to which Cross responded “The future Mr. Gittes! The future!” No doubt electric vehicles and e-commerce should enjoy bright futures for years to come. However, investor behavior implies that America’s roads are populated exclusively by electric vehicles (we don’t live in Orbit City) and that all retail transactions occur online. COVID for sure pulled e-commerce activity forward. However, we believe that e-commerce sales as a percentage of the total Retail pie is likely to shrink as customers venture back out in the physical world to purchase goods and services. That’s to say nothing of the fact that 18 million people remain unemployed and that consumer purchasing power decreases every time the Fed expands the money supply. Last, the Federal government is unlikely to continue paycheck protection and other stimulus programs post the November Presidential election, further weakening the consumer.
The Retail investor trade: We believe that retail money is behind much of the equity valuation run-up that has left logic and reason back on earth. We are aware that various investment banks and others have discounted the impact of the retail investor but they are mistaken. Their analysis points to Robinhood and that platform not being large enough to move markets. Newsflash, Robinhood isn’t the only platform to offer fractional share trading services. There are a number of other fintech companies that offer similar services not to mention Square (SQ), TD Ameritrade (AMTD), Schwab (SCHW) and Fidelity (private) to name a few. In the case of Fidelity, it disclosed that approximately 84% of Q1 total order flow was fractional share order flow. Combine the rise of fractional share trading with the fact that many large asset managers are holding positions and the result is that active retail investors can move individual names.
Fundamentals will eventually matter. The equity market is a macro, momentum-driven trading market at the moment. There are several upcoming events that could shake investor confidence and bring a modicum of valuation reality back to the equity markets:
- Soft Q2 earnings reports: June numbers will be soft for many companies across sectors. Q2 estimates are likely low enough. However, we believe many investors will be surprised that management teams largely will not have significantly better visibility now as compared to the March quarter calls that took place in April. We expect that many companies once again will not provide forward guidance.
- Forward estimates are likely to come down: Q3 and certainly Q4 and 2021 consensus estimates will be reduced in our view.
- Q3 negative earnings surprise: Investors will be surprised to learn that life is not linear and that recoveries are choppy. The current economic recovery will be long, drawn out and painful. The record bankruptcy activity we have experienced is only getting started. More job cuts are coming. High unemployment will have a negative impact on all industries, including Technology. PPP and other stimulus programs are likely to slow and/or expire post-election, exacerbating the unemployment problem.
- The Presidential election: Biden will increase taxes on companies and consumers should he win the general election. Should Trump win re-election we also expect taxes to increase. We can’t afford to increase M1 and M2 in perpetuity without a tax increase. This explicit income tax increase would be in addition to the embedded tax increase that comes with an expansionary monetary policy.