As the Bubble Deflates

After the Party is Over

We have been in the “Growth is the only place to be’ investment regime since 2015. This era began when Janet Yellen indicated in her July 2014 speech that the Fed they would begin the process of rate normalization. You can chart the US Dollar rally and the corresponding collapse in oil prices back to that speech. While eventually she would have to push her hiking timeline out because of the meltdown in early 2016, the market had already begun to seek out high growing companies in an anemic economic growth backdrop.

With the exception of that 2016 bounce in cyclical value stocks, these past six years have been one of the strongest growth stock regimes in history. By most valuation measures, this market, especially the concentrated tech sector, is near or more overvalued than it was in 1999. Not to mention the super high concentration of the top names in the index.  Those who think they’re diversified by investing passively in the market are in for a an enormously rude awakening.

And no, I don’t buy the argument that ‘this time these are different types of companies with real earnings.’  Take the example of Cisco (CSCO). That was a great company with excellent REAL earnings. But at the market peak in March 2000, Cisco was trading at over 100x PE and in the ensuing tech bust the stock was down almost 90% from its peak. All the tech, discretionary and communications companies of today are overvalued, and they will also have their day of reckoning.

Crescat Capital

On the flip side, the cyclical sectors like energy, materials, industrials and even financials are screaming cheap.  And likewise, here, I don’t buy the narrative on these sectors being permanently impaired because of secular decline or structural impediments like regulation.  All these narratives are just that, Narratives.

The question that I most get is why is growth outperforming and why will it stop, and value take over? My answer? Investing is trying to see what expectations are already baked into a price and then trying to be step ahead of those expectations.  Someday, the good news coming out of those growth names is just not that good and it is just not as bad as expected in those beaten down names – that’s where the surprises are, and the reversals take place.  Get those reversals in news enough times and you get the entire regime to revert.  This has happened before and will happen again – just players and the names are different each time.

Growth is outperforming because we have had a handful of companies that have been growing at a very rate, especially compared to the underlying economy, and investors are willing to pay up for that high growth rate in an anemic growth environment.  Given the sky-high valuations, the expectations of that continued growth are also stratospheric.  When, and it is when, that growth rate slows down, those expectations will be dashed, and the high-flying investors will exit as fast as victims trying escape a burning theater. 

On the opposite side of that coin, cyclical stocks, that have not been growing anywhere near the rate of those high growth stocks in this anemic economic environment, are trading at extremely cheap valuations.  This has been exacerbated by the pandemic and some of them were priced for death. They will likely see a bounce in the case of a cyclical reflation.

S&P Energy vs. S&P Technology Since 2011

Circumstances may be converging where we see that tipping point.  Since September, the market has already begun to sniff out the reversal in favor of cyclical value on the backs of the much-awaited fiscal stimulus.  Is that all priced in? I don’t think it is – but that may not push the market too higher as the fiscal juice is ultimately not going to be enough for this liquidity addicted market.

Which brings me to my final point: I think value will outperform in a falling market this time.  We often debate what will be the catalyst for value to outperform and I pose the question as which of the two following historical value environments are more likely to occur this time? The 2000 – 2002 tech bust or the 2003 – 2007 value reflation rally?  I think it’ll be the former rather than the latter, despite the current reflation rally.  Given the nosebleed valuation levels and the super concentration of weight in the indexes among the top 5 stocks, the physics will tell that the market will decline even if there is a simple rotation from growth to value. 

Moreover, I think this coming bear market will be marked by a slow bleeding of prices that will transpire over a two- or three-year period.  It’ll likely be a ‘death-by-a-thousand-cuts’ market where the high spirits, especially of those who have never really seen the whites of the eyes of a bear market, will be slowly snuffed out.  Each rally will bring a sense of optimism, of renewal, only to be dashed by more selling. That’s what the 2000 – 2002 bear market was like, where investors would call the bottom after a selloff only to see lower lows. 

I don’t expect a massive Fed response in that type of an environment as there won’t be a crisis type of a gap down selloff.  There will not be a sudden market collapse to save.  No plunge for the Plunge Protection Team to pounce on. The Fed will probably be focused on monetizing fiscal packages while trying to get above 2% inflation. The push towards MMT and its funding through the Fed’s debt monetization may finally get us the runaway inflation we have been all expecting.  But let’s leave that topic for a different note.

Personal portfolio positions:

Long: Energy Stocks, Cash, Real Estate, Gold, Gold Miners 

Short: Nasdaq