Is the Reddit revolution a sign of the top?
Buffett and Shiller indicators flash extreme caution.
Do social media companies foment violent extremism?
Why the tech bubble should burst.
International equities and commodities make sense.
The current extreme speculative stock behavior combined with the historically high valuations of the S&P 500, FAANG, and OTC stocks, caution of a possible sizeable and prolonged market decline. This letter will analyze current market conditions, highlight three rising market risks, and provide ideas on how to invest through this historic period and a probable protracted bear market.
The chart below shows a massive surge in the trading of small lots in stock options.
Wall Street folklore famously reports that Joe Kennedy exited the stock market before the 1929 crash because a shoeshine boy was giving him stock tips. Kennedy reasoned that by the time the shoeshine boy is giving stock advice there are no more investors to convince to get in.
January’s surges in Koss Corporation (KOSS) up 1857%, GameStop Corporation (GME) up 1737%, AMC Entertainment Holdings, Inc. (AMC) up 519%, Express, Inc. (EXPR) up 476%, and other Reddit or Robinhood short squeeze stocks illustrate frenzied retail stock speculation. These price rises are unsustainable and driven by short position margin calls and social media accentuated crowd madness.
The Reddit or Robinhood short squeeze rises of recent weeks dwarf the astounding 12 month rises in Tesla, Inc (TSLA) up 582% and Grayscale Bitcoin (GBTC) up 208%. These unsustainable and irrational price moves are the anecdotal fodder of major market tops.
Valuations for US equities are at historic highs. The Buffett Indicator is the ratio of US equity market capitalization to the US GDP. The Buffett indicator chart below shows the ratio at an all-time high of 176% and having nearly tripled since the market bottom in 2009 when the ratio was 66%.
The Federal Reserve Model compares the earnings yield of the S&P 500 to the 10-year US Treasury. This model shows that the market is still reasonably priced with an earnings yield of 4.5% compared to a 10-year US Treasury yield of 1.09%; unfortunately, as the year progresses, interest rates should rise and the S&P earnings yield could be endangered by rising corporate tax legislation.
Nobel Prize winner Robert Shiller’s CAPE Ratio is the 10-year average of S&P 500 earnings divided by the S&P 500 Index price. The current CAPE ratio of 33.7 has only been exceeded during the 2000 technology bubble. Corporate tax rates will inevitably rise to fund the current administration’s massive spending and record Federal debt. The imposition of higher taxes will increase the CAPE ratio just as the previous administration’s tax cuts reduced the CAPE from 33.31 to 24.82 from January 2018 to March 2020.
The market should decline when money stops flowing into the market and confidence is lost. With new stimulus checks and fiscal spending to be announced in coming weeks and months, the bull case can still be argued. However, the extreme speculation will likely end badly, and unexpected losses could change market confidence. Iconic trader Paul Tudor Jones once said, “all parabolic moves end badly” and, since 1986, we have found this observation reliable in 1987, 2000, and numerous mini-bubbles since.
Technology Bubble Risk:
Technology and FAANG stocks have seen parabolic rises similar to technology stocks in the 2000 bubble. Last year, COVID-19 created great hardship for traditional businesses like leisure, hospitality, and travel, but benefitted the gig economy stocks whose services were critical for the stay at home economy. Facebook, Inc. (FB), Amazon.com, Inc. (AMZN), Apple Inc. (AAPL), Netflix, Inc. (NFLX) and Alphabet, Inc. (GOOG) enjoyed surging demand and stock prices while lockdown victims experience the opposite fate. This performance dichotomy should reverse as the first, second, and third quarter’s earnings for FAANG and QQQ stocks are reported and those earnings will compare against last year’s blowout earnings. Tech stock earnings momentum will slow and reopening stocks’ earnings momentum will rise reversing last year’s stock performance disparities.
As antitrust lawsuits grow against big tech, concerns about the effects of social media are growing. Consider that Salesforce CEO Marc Benioff has argued that “Facebook is the new cigarettes” and in a CNBC interview in late 2018 he said Facebook should be regulated, just like tobacco. “I think that you do it exactly the same way that you regulated the cigarette industry. Here’s a product: Cigarettes. They’re addictive, they’re not good for you.”
The Netflix documentary film “The Social Dilemma” shows how social media companies [see linked trailer] utilize algorithms used by Facebook and other social media companies to trigger responses that reinforce any idea to increase user traffic and create “fake news” for their financial benefit. Social media algorithms combined with today’s news media’s “narrative” focused business models are driving extreme views – on all sides – that are inherently dangerous. Five-time Emmy Award-winning journalist and New York Times bestselling author Sharyl Attkisson details this narrative phenomenon in her book “Slanted: How the News Media Taught Us to Love Censorship and Hate Journalism.” This toxic culture is leading to an onslaught of legal and regulatory actions against social media companies and could reverse social media’s meteoric rise.
This past week Apple Inc. CEO, Tim Cook criticized the polarization and misinformation on social media in comments at the Computers, Privacy and Data Protection conference. Apple CEO slams social media in Facebook fight | Reuters Video Cook argues social media apps “collect too much personal information and prioritize ‘conspiracy theories and violent incitement simply because of their high rates of engagement.’” As decelerating earnings are met with lawsuits and growing concerns regarding social media, the same feedback loops reinforcement mechanism that trigger clicks and social unrest will rise in the marketplace. A negative feedback loop of decelerating earnings, lawsuits, and souring public opinion could lead to a secular decline in social media stocks and big tech.
Below is a long-term chart of the Nasdaq 100 index (QQQ). Big tech’s historic parabolic move grows more unsustainable while negative business prospects mount.
While social media’s popularity will not fade as fast as The Bee Gees and disco, one has to wonder how long it will be until the public understands the divisive nature of social media and its relationship to violent partisanship in the US.
Rising Interest Rates:
Below is a chart of the constant 30 year US Treasury interest rate. Declining interest rates have revived bull markets following equity market crashes for four decades. If rates continue to rise, due to inflation and excessive debt, the stock market may lose its interest rate crutch and create an environment not seen since the 1970s.
The four-decade decline in interest rates has ended. Higher interest rates will be driven by the inevitable global economic recovery with the elimination of COVID-19 and rising inflation. With rising interest rates, stocks, real estate, and bonds will no longer enjoy rising prices. Stocks will have increasing competition from bonds and stock valuations will struggle along with bond portfolios. Speculative cheap money will fade and borrowers will have to pay more to service their debt. Rising debt servicing costs could be particularly problematic for the US which has $27.853 trillion in debt outstanding that costs about $393 billion a year in debt service.
“Skate to where the puck will be”
Warren Buffett famously responded to the question of how he invests successfully. He said he does what hockey superstar Wayne Gretzky has attributed his success: “I skate to where the puck will be.” While we are not optimistic about returns in the US in the coming years, there are many places to invest where returns are likely to be far more promising. Those areas include equity markets outside the United States including Europe and the emerging markets as well as asset classes like commodities which have not been the wealth-creating assets that stocks, bonds, and real estate have been for the last 40 years.
Future returns correlate directly to entry point prices. While the US markets have led global markets for years, their high valuations make future return prospects poor. Conversely, equity markets in Europe and the emerging markets offer attractive entry points and return prospects.
The chart below by OPCO’s Ari Wald, CFA, CMT shows how European equity markets are poised to appreciate following two decades of consolidation.
Emerging markets trade at less than half the Shiller US CAPE ratios. These markets should appreciate while US financial asset performance declines in the years ahead. The data below from Robert Okata, CFA makes a compelling case for emerging market equity asset allocations.
The case for commodities is that they benefit from rising rates and perform well in periods of weak US equity market performance. The chart below suggests the commodity cycle is turning up.
Gold is a commodity we recommended in September 2019 as a safe haven asset when equity markets were very expensive and before the COVID-19 decline. We sold our gold positions after a sharp runup in August 2020. Again, the yellow metal is a logical safe-haven asset and the equity market is very expensive. In addition to buying gold ETFs like VanEck Vector Gold Miners ETF (GDX) and SPDR Gold Shares (GLD), we are buying the Gabelli Global Gold, Natural Resource, and Income Trust (GGN). GGN is a covered call writing closed-end fund that yields 10%. In combination with other precious metal ETFs, GGN can help provide a compelling total return commodity strategy.
The chart below of the gold ETF (GLD) shows our market timing
While markets are in a tizzy over green energy, clean-burning natural gas is the fossil fuel that can provide reliable energy to power the global economy today and natural gas has led to the United States reducing its carbon footprint. We continue to like Antero Midstream Corporation (AM) which yields 14% and Antero Resources Corporation (AR) which offers a pure-play natural gas turnaround investment with significant insider ownership. The combined companies are the second largest producer of natural gas in the US and third largest natural gas exporter.
Danger signals are flashing, but there are many cross-currents that will impact short term market action. While the market could experience a sharp correction at any moment, it could continue higher until the economy recovers from the COVID-19 pandemic. Investing with a longer-term perspective as advocated by Warren Buffett combined with allocations to international markets and commodities could make what could be a very difficult domestic investment environment in the coming years a rewarding one. In other words, investors should change playbooks from the stock, bond, and real estate interest-sensitive strategy to the 1970s playbook which emphasized commodity investments.
We welcome your feedback.
Tyson Halsey, CFA