Is the Coronavirus Blowing an Equity Bubble?
June 23, 2020
Provocative? It’s a bit odd to name and blame a bubble on the virus, isn’t it? But I hope to show you why that makes at least some sense.
Others, such as Jeremy Grantham, have also recently said we are in a stock bubble. So claiming that we are in a bubble is, by itself, not original.
But my claim is different. The postulate is not that we are in a broad stock market bubble. In fact large parts of the stock market are still in distress, such as airlines, commercial property, and the leisure industry, to name just three.
And most stocks tied to the physical economy, let’s call them main street equities, are in an uncertain recovery tied to the prospects of the US or global economy, and their prospects depend very much on how the economy comes back longer term. Despite ample Fed liquidity and intervention, prices of other risk assets, such as corporate bonds and emerging markets, are still depressed despite the rally since late March, most deservedly.
My claim is much more specific. The bubble, if there is one, involves only a certain specific segment of stocks. Further, the bubble in these specific stocks was already underway before the crisis. But the Covid 19 crisis, instead of squashing the bubble, has actually exacerbated it.
Let me elaborate.
What Bubble?
The epicenter of this equity bubble is in the Technology sector, and is dominated by growth stocks. Growth stocks in general have had a number of good years as the value factor has underperformed. As Figure 1 shows, the divergence accelerated in 2019 and has only become more pronounced since the Covid 19 outbreak.
Large growth stocks returned +9.6% whereas small value stocks returned -31.6% in the one year period that ended in April 2020. This is an unusually large divergence by historical standards; the last time such a large divergence occurred (in favor of growth) was in 1999 during the NASDAQ bubble, followed by a similarly large opposite move in the early 2000s after the 2000 crash..
Figure 1: The dichotomy between large growth stocks and the rest of the market, illustrated here by comparison with small value stocks.
Source: Data from Kenneth French’s website. Cumulative return calculations by author.
At the epicenter of this epicenter, so to speak, sit the mega technology stocks represented by the acronym FANG— Facebook, Amazon, Netflix, Google (Alphabet), sometimes along with Microsoft and Apple (“FANGAM”), At least five of the six are behemoths, and just those six companies add up to about a quarter of the S&P500 market capitalization of $25.8 Trillion.
Let me make it clear that I am not opining here that all or even most of the FANGAM stocks are overvalued at this point. We will make this point even clearer further along.
There are two basic and unassailable reasons for their ascendancy. First, these companies and their ilk represent the global virtual and online economy. The average American spends more than six hours, or about half their waking time, online. Second, through capturing network effects and economies of scale, they have monopoly or oligopoly status in thinly regulated cyberspace.
To these favorites, the burgeoning rally has added a slew of new darlings involved either in providing cyber services such as online shopping, social media , gaming, etc. or the provision of the enabling technology itself. The hot companies in the latter category are involved in AI/ML, 5G and cloud computing.
A third category are the disruptors of segments of the main street economy, which include a diverse set of companies such as Tesla (automotive), and the biotech firms (Healthcare/Pharma). All three of these categories have had sharp runups in price over the past year and a half.
They were also very resilient during the Covid crisis, and many are trading above their pre-crisis levels, for reasons that we will explore below.
Some Extreme Examples
How do we know there is a bubble? Look at the valuations! For example, pre-virus, essentially all of the 31.5% 2019 gain in the S&P 500 came from multiple expansion, none from earnings. So far in 2020, the situation has worsened, as both current earnings and earnings prospects have broadly suffered due to the demand shock from the shutdown, while the growth indexes are up YTD.
One of the clearest symptoms of a bubble is when specific stocks trade outside rationally justifiable bands of valuation. A couple of such examples come to mind - Zoom Video Communications (ZM), and Nikola (NKLA). As Figure 2 shows, these stocks skyrocketed in the midst of the crisis. While the Zoom subscriber and revenues grew very fast during the crisis, their most recent valuation of about $70B, as Figure 2A shows, is at more than 50x their recent annualized revenues of $1.32 B based on 1Q20.
Figure 2A: The small videochat/cloud conferencing app company ZM has zoomed to a valuation of almost $70B during the epidemic
Figure 2B: Nikola, shortly after beginning to trade publicly, has soared to a valuation of over $27B, rivaling US car companies such as Ford and Chrysler, despite having no revenues yet, let alone earnings.
In Nikola’s case, their valuation of $27B rivals established companies such as Ford and Chrysler, and is reminiscent of Tesla’s meteoric rise. But when TSLA’s valuation crossed Ford in April 2017, Tesla had doubled their annual revenue and had the most successful electric car in the market. NKLA, whose price doubled in June 2020, hasn’t even begun making their trucks commercially.
We will not opine on what the long term sustainable valuations for these companies are, but it is clear that they will have to grow dramatically to justify these valuations.
Telltale Characteristics of a Bubble
There have been many bubbles in the past five centuries, each involving crazily overvalued stocks/assets. In Figure 3, we refer to a typical list from the last 400 years, albeit one that favors the past 50 years.
Figure 3: Ten Great Bubbles in History, 1600-2020
Source: “The Role of Narratives in Asset Bubble Formation: The Case of the U.S. Tech Bubble”, by Preston B. Teeter
Such asset bubbles share four key traits that build over time from start to frenzied finish. Let us examine these characteristics, and see how these apply to the current instance.
Built on solid facts : Even the Tulip bubble had an economic foundation. The arguments outlined above for technology growth stocks are solid, but what price level will they be used to justify? For example, as AMZN has rocketed from 1500 to 2500 in a short period, the growth required to justify its elevated valuation has expanded as well.
Fed by a seductive narrative : The key to a bubble is the building up of these solid facts and a growth hypothesis into a narrative that is essentially qualitative. Once valuations are lost sight of, any price can be justified by the narrative, which begins to dominate discourse. The key phrase in any bubble narrative are the famous last words: “This time is different.” Covid 19 has served to reinforce the technology growth narrative.
Transformation into myth : The passage then occurs from narrative to myth, a widely believed framework embraced eventually by the whole market. In this case, the demassification of companies was brought home to investors in a compelling way during the WFH (Work From Home) response to Covid 19, and companies were able to do a mass experiment, largely successful, that showed that remote work was feasible. It also showed the importance of the cyber environment. The myth then allows established metrics like P/E and P/B to be supplanted by Price/Revenue, or even Price per “customer” (AKA market share at any price).
Endorsed by authority and media : This is the last stage in the bubble making process, exemplified by the 1997-2000 period of the NASDAQ bubble. Authority figures such as Alan Greenspan praised what was then called the New Economy, representing America’s response to Japan and other global rivals.
So far, the new technology industry fails on this measure. It has been controversial in global media for its flouting or flubbing of individual privacy rights and cyber security, tolerance of election meddling, etc. Its monopoly status is a source of concern. It is often mentioned but rarely adulated by those in power.
President Trump has criticized and threatened some large technology companies in his tweets. However, unlike in Europe, where lawmakers have legislated individual rights and privacy concerns into law, the US Congress has largely avoided such measures, and been deferential for the most part to the Tech giants, who employ big lobbies. We will have to watch this space to see how the current wave fares.
How the Coronavirus has Expanded the Bubble
We have seen that the new tech growth bubble (if it is indeed one) began before the virus, but it has been further exacerbated by the virus in four ways:
The coronavirus enforced the stay at home environment most conducive for the usage of technology and made online presence crucial to the functioning of most businesses, whether retail, service, or commercial.
The virus disabled large parts of the physical economy, diverting resources and capital into technology and cyberspace. This took the concrete form of people who stopped shopping locally and ordered from Amazon, or who canceled travel and enrolled in an online class.
The virus prompted the US and other governments to unleash huge monetary and fiscal economic stimuli. Such stimuli have largely been top down and broad based, and only a small fraction have targeted specific industries with a subsidy. So a large part of the stimulus and liquidity has ended up benefiting those companies actually thriving during the outbreak by putting money in the hands of consumers, reducing borrowing costs, and improving the investment climate.
Last, and probably least, the virus encouraged the retail day-trading culture encouraged by platforms such as Robin Hood. The importance of this phenomenon is probably overblown, but it gives the bubble its furor and publicity.
A Nine Inning Ballgame—Which Inning are we in?
To answer the question, look at our rendition of the nine innings in a bubble game, shown in Figure 4.
Figure 4: The nine innings in a market bubble game bear a passing resemblance to the seven stages of grief
I won’t keep you in suspense...it looks to me a lot like the fourth inning. Overall, growth stock and technology valuations are not yet extreme, when taken as a whole. The NASDAQ and NASDAQ 100 P/E multiples have risen steadily to about 30-32X trailing earnings, which are historically high (having risen from 15 in 2012) but nowhere near the stratospheric valuations (P/E>100) of the NASDAQ in early 2000.
Therefore, though technology growth stocks are exhibiting the classic symptoms of a bubble, we can’t say they are all (or even mostly) overvalued, or that the FANGAMs are too high, especially right now. In fact their valuations and prospects vary name by name, as with any group. Could Amazon ultimately justify its $1.5+ T valuation through growth? Its entirely possible, Could Tesla justify a $1000 price? If it delivers on its promise, it could be worth even more. And so on. This isn’t about every stock or any specific stock, and it isn’t necessarily about today - its about where it may be going.
Although one can have periods of sharp earnings growth, trailing P/Es do tend to mean revert eventually. As a large group of stocks exhibits a P/E multiple that is historically high, has run up very recently, takes up a large percent of total stock capitalization, and their prices continue to rally, it becomes more likely that the group contains a growing percentage of overvalued stocks, and that there will be a day of reckoning.
But let us rewind. The first inning is an early divergence of a sector or market and the start of a trend. It is arguable that for technology growth stocks, this process began in the early to mid-2010s as the FANGAMs , along with other tech growth companies, began to separate out from the rest of the market.
In the second stage, the phenomenon is recognized, but dismissed as special case or anomaly. At first, this small handful of stocks was thought of as representing a unique new type of social-media and network-effects driven monopoly. Growth and earnings targets were often modest, and the companies handily beat them.
In the third stage, from 2017-2019, before the virus hit, we saw the start of narrative justification by group of experts describing a virtual economy that encompasses many more names and technologies, such as autonomous driving, biotech, service automation, artificial intelligence and machine learning, cloud computing, and 5G wireless technology.
The coronavirus has now ushered in the fourth inning, unleashing the four favorable factors described previously. With the boost from Covid 19, the narrative has broadened to include a larger swath of technology names and is embraced by large segments of the retail and professional investing community.
Over the past four years, the investing community, enthused by the promise of companies like Tesla and Amazon, has driven up multiples of the favored growth stocks even faster than the fast growing earnings of some of these companies. In other cases, companies with no profits but larger user bases have been able to garner very large valuations that are many multiples of their annual sales. The shifting of the narrative from growing earnings to growing revenues without earnings, to simply garnering more users, is a tell-tale sign that the bubble is well on its way.
And so, as we saw, there are now cases like Nikola, a $27 B company with no sales.
What Comes Next?
We don’t know, of course, but if there is a fifth inning, the bubble would be greeted and feted by by media and political power structures - it may, for example, be couched as America’s response to global growth challenges and our answer to China.
As mentioned earlier, the bubble, particularly for the mega cap tech names, will have to overcome privacy, information security, and monopoly concerns to get to this stage. It will also have to overcome the objection that technology destroys jobs and increases inequality. Whether it can do so is a crucial question. The narrative would then take on normative tones- technology as an unquestioned social good and its purveyors as champions.
The sixth innings, the peak, can occur when this belief becomes the broad consensus. At late 1990s multiples, the NASDAQ would be at triple its current price. This is neither a forecast nor even a likely scenario. And of course, it does not end there.
A Caution: We do not know how far this will go, or when or how it will end. But historically, in the final three innings, valuations tend to break against the hard shore of reality and the market begins reversal, the bubble bursts decisively, and finally leaves underlying assets cheap after a painful deleveraging of the same type that started in April 2000 and brought the NASDAQ down from 5000 to below 1500 over the next few years.
Will an Economic Recovery Prick this Bubble?
This is hard to answer. History has shown that a pricked bubble leads to a broad asset selloff including assets that were not part of the bubble. It’s unlikely that a positive economic outcome would cause growth stocks to drop, or at least not in a significant way.
However, a recovery from the coronavirus may prompt a rotation from these stocks back to “physical economy” stocks. This happened briefly in May and early June 2020. That may curb the rally for some time. But the likelihood is that the drivers behind the virtual economy stocks have staying power, for now.
Instead, it is much more likely that the day of reckoning, when it comes, might be precipitated by some event directly tied to the bubble sector. This could take the form of anti-monopoly legislation in the US, or a much more draconian regulatory environment following serious privacy breaches, or simply from an attempt to legislate job creation and redistribution of profits from oligopolistic companies whose huge profits currently accrue principally to shareholders and a relatively small number of employees.
Caveat Emptor! Caveat Venditor!
So maybe I am wrong, but the existence of such a bubble would help explain one of the central paradoxes of the past few months, the seeming divergence between the economy, which is recovering slowly and haltingly, and the stock market, which has soared back. Take out growth, especially tech growth, and the stock recovery looks far more subdued.
And if it is a bubble, it’s likely not about to collapse. So please don’t let me stop you from enjoying the bubble while it lasts, or from sitting it out… Just don’t forget how they run, and how they inevitably end.
Buyer and seller, both beware!
Disclosure: This article is not a buy or sell recommendation for any asset and does not constitute investment advice. The author is long several technology stocks in his personal portfolio, including several mentioned in this article, at the time of publication.