January 28, 2021:
Stock markets have been surging higher, and our favored areas (international and emerging value stocks) really outperformed last quarter. But looking at the whole of 2020, the real craziness took place in growth stocks. In fact, we believe that US growth stocks have become a full-blown speculative bubble.
In today’s article, we’ll outline why we believe this, and why it’s so important.
Late-stage bubbles can really test the mettle of value-focused investors, but they can also be a bonanza once the dust settles – at least, for those who stick to their value discipline. We’ll soon follow up with a second installment discussing our investing approach during the bubble and its likely aftermath. For now, let’s look at what we believe to be the first major bubble in over 15 years.
The two features of a bubble
In our view, an investment must meet a couple of criteria to be considered a major bubble.
First, it must be expensive. Not just a little bit, but excessively so, and usually accompanied by a popular narrative explaining why such extravagant valuations are justified. Rapidly accelerating prices are an especially good indicator, as prices and values often start to move up almost in a straight line during the final stages of a bubble.
But there is also a behavioral element. To quote famed bubble scholar (and founder of the investment firm GMO) Jeremy Grantham: “The single most dependable feature of the late stages of the great bubbles of history has been really crazy investor behavior, especially on the part of individuals.” Widespread investor nuttiness is what separates merely expensive markets from true bubbles, which helps explain why they are also called “speculative manias.”
Let’s score US growth stocks on both of these criteria.
Widespread investor nuttiness: check
The investor antics we’re seeing right now bring back vivid memories of the tech stock and housing bubble peaks. The investments are different, but the euphoria, certitude, and disregard for value are strikingly similar.
- The media celebration of individual investors who’ve hit it big (such as the profiles of Tesla millionaires, aka “Teslanaires,” here and here) follows the pattern we saw in the last two bubbles. For example, this profile of San Diegans who struck it rich in real estate appeared just a few months before the housing bubble peaked.
- A good example of the Teslanaire mentality was on display when a well-known one declared on Twitter that he was leaving the corporate world for good to live off the proceeds of his Tesla shares – which, by the way, he’ll never sell. When asked how he could live off the proceeds without selling, he had an easy answer: he’ll just borrow and go ever deeper into debt, using his (eternally rising) Tesla shares as collateral so that he can keep them forever.(1)
- This chart puts some perspective on just how expensive Tesla has gotten. Despite producing fewer than 1% as many cars as the other auto makers listed on the chart, Tesla’s market value is higher than all the other companies combined. (It’s true that Tesla is involved in a number of products in addition to their cars, but cars account for almost 90% of current revenue, and investors were surely aware of those other business lines before the stock price rocketed up over the past year).(2,6) By the way, Tesla’s stock price has more than doubled since the chart was made.
Source: GMO
- The Wall Street Journal notes that “a new army of social media-enabled day traders is helping push stocks to records and turning companies into market sensations.” When this herd stampedes into stocks on a whim (and rarely with any good fundamental reason) the results can be explosive. A few examples:
- Not to pile on Tesla (ok, we want to pile on Tesla), CEO Elon Musk sent a Tweet saying “Use Signal,” presumably referring to the encrypted messaging app of the same name. Investors immediately went out and bought the stock of a company called Signal Advance, sending it up 6,350% in 2 days. The only problem: Signal Advance has nothing to do with the company that makes the Signal messaging app. (This type of mistaken identity by ill-informed traders happened in the dot-com bubble too).(2)
- Hertz stock rallied almost 900% last spring after Hertz declared bankruptcy, even though bankruptcy usually results in stockholders being mostly wiped out. Hertz management and the SEC both said the stock would almost certainly be worthless even if the business recovered, but investors were undeterred.(3)
- Gamestop, a struggling brick-and-mortar business, has seen its stock rise over 1640% in 2 weeks thanks to “tens of thousands of average Joe day-traders whose fervor for a left-for-dead retailer has become a self-fulfilling prophecy.”(2)
Source: stockcharts.com
- The day trader army is particularly fond of call options, which are risky financial instruments used to speculate that stock prices will rise in the short term. The chart below shows that individual investors have been buying call options in vast excess to anything seen even during the dot-com bubble.
Source: Sentimentrader
- Another sign of excess can be seen in investor’s hunger for IPOs (initial public offerings).
- The surge of IPOs during the dot-com bubble was later viewed as a sign that things had gotten out of control. Well, last year’s 480 IPOs actually beat the 406 IPOs that came to market during the dot-com peak in 2000.(4)
- More than half of the companies going public did so via “SPACs”, also known as “blank-check companies,” which allow firms to go public in a faster, less regulated, and significantly-higher-fee (to investors) manner than with the traditional IPO. SPAC issuance exploded last year, and there are now multiple ETFs to invest in the SPAC boom.(4,5)
Source: GMO
- As in the dot-com boom, the excess of IPOs doesn’t seem to have hurt their share prices:
Source: Investech Research
Investor behavior is equally, and in some cases more, crazy than anything we saw in the dot-com and housing bubbles. Scored on the basis of “widespread investor nuttiness,” this certainly seems to qualify as a bubble.
Excessive valuations: check
Moving on to valuations, here’s a chart showing how expensive US growth stocks have been relative to the overall US stock market for the last 5 decades:
Source: GMO
Given that “growth stock” companies grow faster than average, they deserve to trade at a premium to the overall market, and they typically have. As the orange line shows, the middle of the road relationship over the past 50 years has been for growth stocks to be 1.5 times as expensive as the overall market.
But once in a while, growth stocks have gotten ahead of themselves.
First, in the early 1970s, the “Nifty Fifty” bubble saw blue-chip growth stocks pull way ahead of the overall market, only to drop back to their typical relationship when the Nifty Fifty stocks tanked during the ensuing bear market.
Next, the big spike peaking in 2000 was the dot-com bubble. We all know that didn’t end well, and the graph shows that growth stocks quickly declined to (and eventually below) their typical relative values.
The third episode is right now. Growth stock relative valuations are currently higher than at any time outside the very peak years of the dot-com bubble. As in that bubble, today’s relative valuation has curved rapidly upward in a very bubble-like pattern. Quoting bubble historian Grantham again: “It is precisely what you should expect from a late-stage bubble: an accelerating, nearly vertical stage of unknowable length – but typically short.”
That chart shows the relative valuation between growth stocks and the overall market. Could it just be that growth stocks are reasonable, and the rest of the market has gotten really cheap? It could in theory, but the reality is quite different. The overall US stock market is actually near its most expensive ever across a variety of valuation measures, as the following chart shows:
Source: GMO
Summing it up: against the background of an already very expensive market, growth stock relative values have rapidly accelerated to levels that have only been seen once before – and that was during the biggest bubble in US stock market history.
We think that the combination of maniacal investor behavior and the parabolic rise in valuations points to a clear conclusion: US growth stocks are in the midst of a major speculative bubble.
What about low rates?
Every bubble has its narrative – a rationale for why the old way of valuing an investment no longer applies. Because these stories have elements of truth to them, and because they seem to explain the rapid price changes taking place, they can sound very compelling. But they are flawed, and bubble participants tend to remain blind to those flaws for as long as they’re making money hand over fist.
The main narrative among those seeking to rationalize today’s prices is that low interest rates justify high stock valuations. The idea is that because cash and bonds provide such a low return, investors are willing to pay higher prices for other investments, including stocks. Nobody prefers to pay more for investments; future returns will be better with a lower purchase price than a higher one. But even when buying stocks at these higher prices, the theory holds, the return will still likely be better than 0% from cash and ~1% from bonds.
It is true that rates are very low, and that were they to remain so indefinitely, it could justify higher stock valuations (and lower expected returns). However, there are several reasons to doubt this as an explanation for the huge move in growth stocks.
- If low rates are driving other asset prices higher, then why is the effect primarily seen in growth stocks? It’s true that permanently lower rates would give a bigger boost to growth stocks than the rest of the market (by rendering discounted future earnings more valuable) – but not to anywhere near the degree seen in the graph of relative valuations above. Similarly, valuations are much lower outside the US, despite even lower bond yields in many of those countries. This suggests that there’s something more going on than low rates.
- The case for low rates supporting higher valuations rests on the willingness of investors to accept lower future returns from their stocks. But we don’t get the impression that investors are saying, “Cash and bonds yield nothing, so we have no choice but to buy these high-valued growth stocks with the hope of eking out a few percent per year.” On the contrary, future return expectations are anywhere between lofty and euphoric – just ask the Teslanaires.
- In any case, this rationale only works for as long as rates stay unusually low. Will they? Maybe, but it seems sensible to at least allow for the possibility that they won’t, especially given that they only got here because of a temporary-in-nature pandemic. It’s true that central banks have pledged to keep monetary policy easy for a long while, but that will likely change eventually, and maybe sooner should inflation pick up too much. If that ever happens, the support for high valuations disappears.
- More generally, bond rates are (depending on the bond) at or near the lowest they’ve ever been, which is another way of saying that bonds are the most expensive they’ve ever been. This argument basically boils down to saying, “Stocks aren’t that expensive when you compare them to this other asset that’s the most expensive it’s ever been.” It’s not all that compelling!
The idea that low rates justify the surge in growth stock valuations sounds appealing at first, like a good bubble narrative should – but further scrutiny reveals that it has multiple serious flaws.
What about tech disruption? (Echoes of 1999)
Another rationalization involves the potential of new technologies and the companies that make them. There are indeed many exciting technological breakthroughs taking place, and there will surely be some big winners among today’s pricey growth stocks. The problem is that they are priced like they’ll all be huge winners, and that’s not how the economy works.
This narrative closely parallels the dot-com bubble of the late 1990s. Back then, it was thought that the internet would unleash endless productivity gains and a new era of prosperity. Tech stocks rocketed up as a result, leaving “old economy” companies in the dust and humiliating doubters who (it was thought by the bubble crowd) just didn’t get it.
The internet did indeed turn out to be a transformative technology that changed everything, and some dominant companies emerged from that period. But this was not enough to meet the delirious expectations that were priced into tech stocks: once the party stopped, the tech-heavy NASDAQ 100 index fell by 83% and took 15 years to get back to its bubble peak.(2)
Aside from the fact that there is always technological progress taking place, even the occasional disruptive breakthrough is not a credible reason for valuations to become unanchored from reality. We see this, too, as a misguided explanation for the meteoric rise in overall growth stock valuations.
Conclusion – part 1
The abrupt rise in valuations, the manic investor behavior, and the tantalizing-but-flawed rationalizations all point to the same conclusion. We think this is the real deal: the first truly major bubble since the housing bubble, and the dot-com bubble before that.
We don’t know how long it will last or how high it will go (bubbles are famously unpredictable on this front). But we do feel fairly confident that, like every single bubble before it, this one will burst and leave many investors wondering how they ever believed what they did.
The bubbliest areas of the market are at risk of a brutal decline on par with what took place after the dot-com bubble. Fortunately, as was the case in that bubble, some other areas of the market are reasonably priced and have good long-term prospects. Being on the right side of this valuation disparity will, we believe, provide a substantial advantage once the bubble reaches its peak.
In our next article, we’ll share some thoughts on the investment approach we’re taking in this environment.
1 – Source twitter.com
2 – Source stockcharts.com, as of 1/27/2021
3 – Source gmo.com
4 – Source gmo.com
5 – Source wsj.com
6 – Source cnbc.com
Excerpted from a letter sent to clients on January 28, 2021. We mentioned a few individual stocks in this article purely for anecdotal purposes – nothing in this article should be viewed as investment advice regarding individual stocks.