I was debating on what to name this article. “Tired Bull”? “Out of Steam”? But it might just be best to borrow President Trump’s style in the most direct way possible.
On March 23rd, I wrote an article called “A MAN’S MOST VALUED POSSESSION — THOUGHTS ON THE FED’S RECENT REACTIONS” in which I discussed that the Fed’s action, though both immoral and illegal, would ensure that the March low stay intact and never to be tested again. Specifically, in that article I wrote:
“After all, it makes no sense to drop further when the monetary regulator in the whole economy has completely set its mind onto protecting the valuation of the capital markets. I believe the rebounds will be fast and furious and it wouldn’t surprise me that the NASDAQ, at least, finished the year in the green.”
If you have followed the market, you would know that it happened exactly as I predicted. I have also traded accordingly, I loaded up on high-quality tech companies on March 22nd: Facebook, Amazon, Apple, Nvidia, Yum, Bilibili, Salesforce, Alibaba, Nike, Tesla, Zoom. In this period, as of today (Tuesday, March 12, 2020), my portfolio grew roughly 40% and is currently up 8% Year-to-date.
However, what I did not anticipate was the way that the equities have been traded since I wrote the article, especially the technology sector. I knew they would outperform in a bullish market but what happened was completely unexpected.
Most technology names are currently at their previous all-time-high level if not already blown past it. The price appreciation of technology stocks isn’t without reasons.
· The virus dealt the last blow to retail and malls. Amazon will be the unchallenged retail monopoly for years to come.
· Sales are moving online which benefits cloud providers such as Microsoft, Amazon, and Alibaba.
· Google and Facebook also benefit tremendously due to the demand for online advertising in the new world order of online shopping.
· Salesforce, as an acquisition business, benefits immensely due to the cheap financing cost brought in by the Federal Reserve.
But we must rationally sit down and ask ourselves, is it still a good time to ride the equities or if so, how much is enough?
That is the question I am trying to address here:
I believe that the equities are overbought at the current level. If you already bought, congratulations, it is time to take money off the table. If you haven’t bought and are looking for an entry, this simply isn’t the level you want to get into the market.
I will discuss Five reasons in details:
Jobs: The market is currently pricing in the expectation that over 90% of the layoff positions will be filled by the end of Q2. It is a false thought. It isn’t just an overly optimistic thought. It is a false expectation. First of all, many jobs were lost due to corporate bankruptcies, e.g. JC Penny, Macys, Neiman Marcus, etc. Therefore, for these people, there is simply no way to ever get these jobs back, as they are lost forever. Secondly, even for companies that are still operating, the reality is that most layoff positions will not be filled in the foreseeable future. For example, Airbnb has already clarified that the 1,900 office workers that it laid off are leaving on a permanent basis. It does not have any plan to hire them back. As a result, these workers will be looking at new positions elsewhere to work in order to keep paying rent and buying groceries. The exact same story is happening with Uber, Deloitte, etc. Thirdly, even the companies that are safe and doing relatively well (Amazon, Facebook, etc.) are faced with a large degree of uncertainty, which means they are not going to expand and increase their labor demand. Therefore, in conclusion, what we have is a large number of people losing jobs, rushing back to the labor market trying to gain new employment opportunities, and few is available. Definitively, the market is wrong on jobs and the pricing will adjust accordingly once the market realizes the most jobs are not coming back.
Deleveraging: This will be a more difficult point to understand if you are not coming from a capital markets background. In short, there will be deleveraging in the foreseeable future. Deleveraging means that companies will shed debt by paying them off instead of taking on debt in order to invest in new projects. Why would companies decrease their debt load when the interest is zero? It seems to be contradicting what Finance textbooks taught us. The reason is that most companies had near-death experiences this time around, including major names like Boeing or Disney. They experienced little to no revenue and need to take on debt in order to merely survive. As a result, the amount of debt issuance in the past month is through the roof. Companies are issuing debt to acquire liquidity in order to survive. However, these cash will run out before profitable investment opportunities arise. Therefore, the companies will simply go back to their old selves, but with a lot more debt. Therefore, coronavirus, if nothing else, forced the companies to leverage up and are now more vulnerable than ever before. Logically, they will slim down operations and cut expenses in order to stay afloat. In a way, it is analogous to the zombie banks in Japan in 1990s. They will be ultra-risk-averse and look to deleverage.
Consumption: Related to the previous two points, when people lose jobs, what do they do first? They cut their consumption. That new iPhone that they wanted to buy, the TV that they wanted to change, and the new gardening tool that they wanted to replenish, all these gotta wait now. The same goes with companies. When companies deleverage, they forego their investment ideas. They do not expand their teams or change to a nicer office building. Disney is not going to build new resorts or parks. Consumption accounts for 70% of the GDP in the US and most developed world. The rest is made up by investment/saving, and government spending. So, let’s see if government spending could save us.
– Previously, we have established that consumption will experience a dramatic decline. Therefore, we look to government spending in order to offset that. However, since most companies, publicly traded or mom-and-pop shops will experience a decline in sales and profitability, revenue/tax collection will be a major challenge. The funding in government spending comes from either tax collection or borrowing (taking on debt). At a local level (state & municipals), there are often clear requirements on balancing budgets. Therefore, if the government could not collect sufficient tax dollars to support its programs, it must cut the spending. Therefore, it is safe to see that not only is government spending at a local level unable to offset the decline in consumption, it might even decline itself, dragging GDP even lower.
– What about at a federal level? At a federal level, there is no limit to the budget deficit the US government can take on. However, it has its own issues.
1) There may not be sufficient demand for the US debt. The virus has affected globally. It is hard to imagine institutions around the world are enthusiastic to take out cash to lend to the US government at a 0% interest rate. Furthermore, China has traditionally been a major buyer of US government bonds and Treasury securities. However, US has threatened China on possibly not paying back its debt. It is hard to expect China to lend more to the US.
2) Let’s assume, for the sake of argument, that the US does borrow & spend an unprecedented amount of money (8 Trillion or above in this year), this will cause the deficit to skyrocket. Academically, it is unclear what government deficit actually causes. Empirically, however, it causes its currency to depreciate and forces the government to raise tax rate in order to collect money to pay back its debt.
Bonus Point: Airlines & Hospitality:
Currently, the market is overly optimistic about the prospect of airlines. I believe that the market is making a big mistake. At the very least, there will be regulations on passenger density. There is a greater-than-50% likelihood that middle seats will be removed for the foreseeable future. If the middle seat is removed, no airline in the US will be able to fly its passengers at the previous price levels. Thus, they must raise prices. If they raise the price by 50%, it will offset the decline in the number of passengers. (100*3 = 150 * 2) However, it is far from that simple. It is certainty that some people will decide not to fly if the prices are 150 instead of 100. Many businesses may opt for Zoom meetings instead of flying its executives to another city for a face-to-face meeting. Therefore, a price increase of more than 50% is surely needed. However, each dollar the airlines increase will drive away a certain number of passengers until the airlines reach an equilibrium. I believe that this equilibrium is close to 80% price increase and losing 44% of its passengers. This will give airlines the same level of profitability. However, the decline in passengers will create a ripple effect and hurt the hospitality industry. Hotels will have fewer guests and must raise the price as well. Now, the burden of a higher hotel price builds on the existing higher flight fare, driving more customers away. It is hard to say where this ripple effect will stop and reach an equilibrium. Nonetheless, it is safe to conclude that airlines and hospitality will suffer quite a bit. Travelling and tourism return to being a luxury good from a common good that it currently is.
Conclusion: The recent bull run has merit but the exuberance is over-done to the point of irrationality. The current valuation levels are frothy. It is time to take money off the table or to wait to invest.
Finally, a few additional/peripheral points to support this conclusion:
– The trading volume is down considerably. This shows that buyers are increasingly cautious.
– When the news came out that Trump’s administration is exploring ways to retaliate against China, the market did not react. This shows that retail money is dominating the market and price actions. Retail traders notoriously over-emphasize company-specific information and under-emphasize macro information.
– On Tuesday, March 12th, the market exhibited a famous trend reversal indicator. Many technology stocks made new highs in the trend in the intra-day, while closing red. This is a strong trend reversal indicator.