Caution

Caution

Published On: February 22, 2021

Written by: Ben Atwater and Matt Malick

Examples of excess liquidity and frothy capital markets abound, from the preponderance of “blank check companies” funneling capital into tech companies, to Robinhood speculators battling hedge fund managers as they trade relatively worthless companies back and forth, to Tesla’s nosebleed valuation and ever-rising stock price, to Bitcoin’s 1,000% rise since March of last year.
 
Just this year, American financiers launched 145 new blank check companies (also known as “special purpose acquisition vehicles,” or SPACs) which raise funds to acquire a company in the future, typically without specifying the company, the target industry, the anticipated debt load or an acquisition price.  Year-to-date, investors have piled over $83 billion into SPACs, more than the previous decade combined. 
 
Often these SPACs are eyeing companies in the technology sector, where market conditions feel much like the early 2000s.  In a funny anecdote, Tesla’s aberrant CEO Elon Musk recently tweeted about joining a service called Clubhouse for a conversation with the CEO of Robinhood, an online brokerage popular with a growing wave of speculative day traders.  (Wikipedia describes Clubhouse as “an invitation-only audio-chat social networking app,” which sounds curiously like a phone call to us.)
 
In response to Musk’s tweet, investors piled into Clubhouse Media Group, temporarily driving the stock up over 1,000%.  Never mind that Clubhouse Media Group is a small Chinese marketing and media firm that has nothing to do with the Clubhouse app that Musk referenced.   
 
Speaking of Musk, Tesla may be the poster child for irrationally valued “tech” stocks, sporting a 1,200+ price-to-earnings ratio amid the media’s obsession with electric vehicles.  Even if every American wanted to drive an EV (they do not), or governments banned internal combustion engines (not likely for quite some time), it is hard to imagine Tesla completely dominating the historically crowded auto industry and justifying even a fraction of its current valuation.
 
In an essay last year, we wrote that “…the longer interest rates stay around zero, the higher the probability that money will drift to some strange places.”  Perhaps none is stranger than Bitcoin.
 
Not quite a currency, certainly not a stable store of value, Bitcoin pays no income and has no inherent utility.  In a world threatened by climate change, the supercomputers that “mine” new Bitcoins consume more electricity per year than Argentina.  And drug smugglers, arms dealers, human traffickers and various other criminals commonly finance their illicit activities via Bitcoin because it is difficult to trace.  As one Twitter user quipped, “imagine if keeping your car idling 24/7 produced solved Sudokus you could trade for heroin.”  Quite an apropos analogy. 
 
Along with these anecdotes, many quantitative indicators suggest peak optimism.  
 
Over the counter (OTC) stocks or “penny stocks” are those that speculators and individual investors buy and sell.  These stocks are on target to trade an astounding 2 trillion shares in February, a record that leaves every other month in the dust. 
 
As a matter of fact, the less money a company makes, and the lower its share price, the more it attracts volume and buying interest of late.  The lowest dollar priced 300 stocks in the Russell 3000 index have outperformed the highest 300 by more than 35% so far this year. 
 
Meanwhile, debt issuance for companies with poor credit ratings (“junk bonds”) is at an all-time monthly high, more than $8 billion.  The demand for low yielding investments from risky companies shows evidence of yield-chasing and overconfidence in companies’ ultimate ability to repay. 
 
Bank of America’s fund manager survey, released this month, shows professional investors are also euphoric.  The percentage of managers taking on “higher than normal risk levels” is at an all-time high.  The same goes for fund managers’ global equity allocations, also at a record high.  For professionals, the most popular trades are long technology and long Bitcoin.  Sound familiar? 
 
It is not just managers, but stock analysts (a group of professionals with a checkered history) are the most optimistic they have ever been.  Analysts have been upgrading profit estimates relative to those they are downgrading at a record rate. 
 
Commonly in markets, the more trading volume, the higher the volatility.  However, as we write this, the 200-day volume range is at 100%, while the 200-day volatility index (VIX) volume range is at 0%.  In other words, while trading flourishes, the hedging of risk is withering.  The opposite of what should be occurring.
 
Investors are fleeing TLT, iShares 20+ Year Treasury Bond ETF, as interest rates rise slightly, and investors move from haven Treasury Bonds to more aggressive investments.  For example, S&P 500 Index ETFs as a group recently registered record weekly inflows.  And, over the last six weeks, money flows into technology stock funds have also reached a record. 
 
The anecdotes and data we outline above suggest that sentiment is overheated, and markets may be priced to perfection.  This risk is especially acute if intermediate and long-term interest rates continue to rise.  After all, many strategists and traders have dismissed high equity market valuations because bonds yield virtually nothing.
 
We do not believe in market timing because nobody has ever proven the ability to know when to get out and then when to get back into the market, a two-step process.  Rather, we will ride out market gyrations every time because we invest in companies with underlying value – companies that generate cash, earnings, dividends and that repurchase their shares. 
 
Buying into investments with no fundamental value is a zero-sum game.  You will make money if the next speculator is willing to pay more, but when the bottom falls out, there is no intrinsic value as a safety net.  At this point in the cycle, critics might perceive this approach as antiquated, shortsighted and narrow minded, but that is why manias persist. 
 

Essays:

Essays:

A Few Years Before

Apr 12, 2021

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