Current market valuations are extreme, but overvaluations can persist for long periods before a market peaks. Today, several negative factors are increasingly weighing on the market, while the benefit of the economic recovery is increasingly being fully discounted into the market. At some point, like the game of Jenga, the market’s impressive bull market will fall apart.
The S&P 500 index has priced in much of the recovery in GDP and earnings. The Fed Model or Risk Premium chart below shows the blended S&P 500 earnings estimates have risen (see second panel red line) 53% rise off the bottom — from 135.92 in May 2020 to 208.6 today.
On a close examination of the Fed Model’s dataset below, blended S&P 500 earnings are 20% higher than yearend 2019, before COVID-19 hit our economy. This earnings growth over pre-pandemic earnings suggests that much of the earnings rebound is priced in. Current excessive valuations are principally the result of artificially low-interest rates created by the massive financial operations of the Federal Reserve in concert with central banks around the world. Commencing in the coming months, the pending taper of asset purchases by the Federal Reserve followed by its gradual hiking of interest rates will remove a key block from the Jenga stack.
With COVID-19’s first wave, the 10-year US Treasury Note yield declined from 1.874% to 0.56% by August 2020. Last August, when vaccine prospects started becoming a reality, interest rates began rising and peaked in March at 1.73%, when the Delta variant first started to be reported. With the rise of the Delta variant, lockdowns lowered economic expectations and 10-year US Treasury Note rates dropped to 1.15%. These lower interest rates improved the market Risk Premium and stocks have pushed persistently higher along with S&P 500 earnings.
The Greater Fool Theory:
The Federal Reserve’s mandate is full employment with modest inflation. Since millions of new jobs still need to be filled, predicting when the Federal Reserve will stop buying $120 billion of US Treasuries and mortgages per month creates a “greater fool” environment for equity investors. The “greater fool theory” is the idea that stock buyers will buy something at an excessive valuation because there is a “greater fool” who will buy today’s overpriced investment from them at an even higher valuation in the future.
With the Delta variant cases cresting, interest rates have begun to rise. Rising interest rates will lower the market’s risk premium, making the market more expensive, and likely triggering a market correction.
The Great Rotation:
With lockdowns decelerating, the economic reopening trade where — bond yields rise, cyclicals strengthen, and tech stocks fade — is re-engaging. As the Delta variant wave of the last four months fades and the economy reaccelerates, interest rates should surpass their March 1.73% peak and push 2% in the coming quarters.
In a recent interview of John Paulson on The David Rubenstein Show, the brilliant hedge fund manager argued for a rotation out of bonds and money markets, as interest rates will rise. Paulson predicted that inflation will not be “transitory” as has been repeatedly stated by Federal Reserve Chairman Jerome Powell. Paulson, who famously made $15 billion for his investors during the subprime crisis, explained that unlike the Federal Reserve’s easings in 2009 — when banks were mandated to strengthen their balance sheets and banks absorbed the excess liquidity onto their balance sheets – today’s excess liquidity is going into money supply and that surplus money supply will drive inflation higher. This rise in inflation should benefit gold, but, due to the corrosive effect of inflation, will hurt bonds and money market products. And since the size of the bond and cash equivalent markets are orders of magnitude larger than the gold market, gold could be a significant outperformer in the years ahead.
The chart below of M2 money supply has grown steadily until its recent 32% jump between January 2020 and June 2021. Following the 2009 Financial Crisis money supply did not jump as it has done recently.
How large have the Federal Reserve’s operations been? The chart below shows that the Federal Reserve’s balance sheet has grown to over $8 trillion. In a normal market, we would expect global institutions and governments to buy all our US Treasuries. In an aberration from a normal Keynesian deficit spending cycle, these massive Fed balance sheet purchases of assets is known as Modern Monetary Theory. We fear this theory is inherently unsound. Unfortunately, some are using this monetary concept to justify seemingly unlimited government spending.
As we head into the Fall, employment numbers will improve as unemployment benefits disappear, and the Fed will stop its monthly $120 billion purchases of US Treasuries and mortgages. The Federal Reserve’s justification for these purchases to support the economy is fading. As rates restart rising in the coming weeks and months, these higher interest rates will make equity valuations even more excessive and hurt pandemic beneficiaries like technology and long-duration stocks, in particular.
The Technology Bubble:
Reopening behavior has already begun manifesting itself through earnings decelerations in high multiples in technology stocks. In July, Amazon reported a slowdown in earnings and dropped sharply. Likewise, last week, Zoom Video Communications, Inc (NYSE – ZM) dropped nearly 20% after reporting a significant deceleration in their revenue momentum. We anticipate more price drops in overvalued tech stocks as individuals return to work and life returns to normal. The chart below by Crescat Capital LLC makes the case that current share valuations of technology stocks are more excessive than in the 2000 Technology Bubble.
KCI Research Ltd. summarized several top technology stocks’ free cashflow yields below. While nobody questions the formidable franchises these companies have, their valuations, with likely rising interest rates and reopening driven earnings decelerations, are precarious.
- Apple (NASDAQ: AAPL) – 2021 Estimated 4.0% Free Cash Flow Yield
- Microsoft (NASDAQ: MSFT) – 2021 Estimated 2.0% Free Cash Flow Yield
- Amazon (NASDAQ: AMZN) – 2021 Estimated 1.2% Free Cash Flow Yield
- Alphabet (NASDAQ: GOOGL) (NASDAQ:GOOG) – 2021 Estimated 5.2% Free Cash Flow Yield
- Facebook (NASDAQ: FB) – 2021 Estimated 2.3% Free Cash Flow Yield
- Tesla (NASDAQ: TSLA) – 2021 Estimated 0.4% Free Cash Flow Yield
- Nvidia (NASDAQ: NVDA) – 2021 Estimated 0.7% Free Cash Flow Yield
Taxes:
Another negative that should weigh on the market in the coming months is the prospect for higher tax rates. The government is promoting the most reckless spending spree in history with $5 trillion in spending to promote unnecessary new government programs. This new spending will have to be paid for through higher income taxes, corporate income taxes, capital gains taxes and further Federal debt. These taxes will reduce corporate after-tax earnings and exacerbate current equity valuations. Higher capital gain tax prospects will create more investor equity selling which will pressure the market before year-end.
Investment Summary:
We continue to forecast a reflationary investment environment, like the 1970s and the 1999-2007 period when commodities and inflationary cyclical stocks outperformed, and bonds and long duration equities underperformed.
Energy should continue to appreciate as the economy strengthens and inflation boosts energy prices. Master Limited Partnerships should provide attractive tax-advantaged income and benefit from higher energy prices and limited new energy infrastructure. Natural gas, we believe, is the breakaway winner in the energy space. Renewables which generate only a fraction of the world’s energy needs will continue to grow at a modest pace but will not meaningfully replace fossil fuels. Due to the high carbon footprint of coal and oil, these fossil fuels will see continued pushback leaving natural gas positioned as the obvious winner for the next two decades. Watch this macro overview of the global energy market by Tellurian Inc. Executive Chairman Charif Souki.
Antero Midstream, Inc. (NYSE – AM) and Antero Resources, Inc. (NYSE – AR) pulled back with natural gas prices in recent months, but we remain positive on them as they have excellent drilling prospects with their Utica Marcellus shale positioning and a sophisticated management team. Tellurian, Inc. (NASDAQ – TELL) is another natural gas investment we are adding to in our energy allocation.
Tellurian Inc. appears to have a transformative business model with a proven CEO who is a “legend” in the LNG business. Investing in executives with proven past successes, such as Elon Musk or Steve Jobs, makes sense. Charif Souki co-founded and was co-CEO of Cheniere Energy, Inc. (NYSE- LNG). TELL has secured three world-class partners in Gunvor Singapore Pte Ltd., Vitol Inc., and Shell NA LNG this year.
Souki appears to be executing very deliberately on its plan. He has weekly investor Zoom calls on its website. As explained above, the natural gas space is experiencing strong global growth. Further, the US to international price spread looks to be a massive moneymaker. Securing the financing for the Driftwood project is the company’s sole focus. This financing will be an iterative process until “FID” Final Investment Decision. We expect the purchase of an upstream property in the coming weeks and months will make TELL a stronger company by year-end and positioned for the FID. Last week, Morgan Stanley published a $22 price target on FID and TELL’s own price estimate is $12-15/share on FID. The risk is they will not secure the money to construct the Driftwood liquefaction facility for international export. This company reminds me of Tesla in 2013 when the company was approaching a massive engineering and technical project, and success was not assured.
TELL is a risky investment, but its return profile is asymmetric. That means there is 100% downside versus 400-700% upside. Those are very compelling asymmetric odds.
We continue to like the steel stocks like US Steel and Cleveland Cliffs, and KCI Research has made solid fundamental cases for these investments.
We will be adding to our positions in the gold market over the coming months through ETFs SPDR Gold Shares (GLD), VanEck Vectors Gold Miners ETF (NYSE – GDX), and CEF GAMCO Global Gold, Natural Resources & Income Trust (NYSE – GGN). Our individual gold stock holdings are Barrick Gold Corporation (NASDAQ – GOLD) and Sibanye Stillwater Limited (NASDAQ – SBSW) a South African gold and platinum miner.
While we have been overly cautious on tech for nearly one year, experience has shown us that markets are cyclical and periods of significant overvaluation following parabolic runs end badly. We recommend raising 20-30% cash in retirement accounts, and, in taxable accounts, considering selling securities with nosebleed valuations and parabolic price charts that will likely experience tax selling and or a valuation correction.
These are extraordinary times. The COVID-19 pandemic has had a massive global impact and it is not yet over. The financial operations by the Federal Reserve helped to stave off a potentially severe recession or depression, but have led to artificially low-interest rates, which in turn have boosted stock valuations to artificially high prices. While a market crash is not our forecast, a correction and rotation from interest-rate sensitive investments will likely lead to years of underperformance for those oblivious to market history and stock market risks.
We welcome your thoughts and comments.
Sincerely,
Tyson Halsey