Note: This article is a rebuttal piece to Open Insight’s 7th Newsletter.
Howard Marks famously wrote in his book, “The Most Important Thing” about the power of the pendulum:
Those who believe that the pendulum will move in one direction forever – or reside at an extreme forever – eventually will lose huge sums. Those who understand the pendulum’s behavior can benefit enormously.
We bolded the keyword here – eventually. The problem with value investors (us) is usually of an issue of being too early. Value investors ignore psychological elements and buy too early leading to mispricings getting more mispriced, and sell too early when valuations tend to swing massively to the other side.
This tendency of being too early is what gives value investing its real edge, which is that value investors tend to have to stomach years of underperformance before outperforming for many years. We are not saying that value investors are always going to outperform, but the art of value investing is not easy, and as Charlie Munger famously said:
It’s not supposed to be easy. Anyone who finds it easy is stupid.
So taking a step back and looking at some of the flaws in value investing, we can incorporate other elements to help guide the way we think about market structures, liquidity, and ultimately cycles. And if you understand market cycles, you can benefit greatly.
- Rule No. 1: Most things will prove to be cyclical.
- Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.
~ Howard Marks
Now that we got the introduction out of the way. The prevailing narrative that technology stocks are overvalued shouldn’t be news to anyone following the market. If investors and market observers were true to themselves, Tesla, the poster-child of the current tech rally, has been overvalued since 2013. You can’t value Tesla on cash flow or earnings because it really doesn’t have any. Most of the cash flows and earnings come from government subsidies. Imagine buying a business where the government subsidy was your only source of income, does that sound like a valuable business to you?
So let’s face it – value investors or rational investors have been wrong on Tesla for years now and if you really want to get precise – wrong for 7 years and counting. But the point we are trying to make here is that anomalies like the ones we see in Tesla are more an indication of a market structure rather than a specific one.
There are reasons investors gravitate towards high growth tech stocks, and many people like Open Square Capital have pointed out it’s because of the zero interest rate Fed policy.
When the prospects of global growth are low (as reflected in low-interest rates), investors end up chasing for yield. This is why you see governments issuing 100-year bonds where that was one of the best performers in 2019.
So there is a very valid reason today as to why growth has outperformed value, no one is going to dispute this and the chart above illustrates this correlation in outperformance as such.
But as I would like to say when I’m making an argument against this time is different:
To say this is not a bubble is like looking at a sumo wrestler and saying he isn’t fat. Because he’s being compared to other sumo wrestlers. No, he’s still fat and will have health issues.
(P.S. Surprise, it’s scientifically backed too.)
The single biggest problem with (you can call it human psychology if you like) the market today is that people try very hard to justify why things happen. Rather than simply say that momentum is what’s driving stock prices up, people have this obsession of trying to justify the move with a story.
“Oh, yields went lower, so tech stocks should be valued here.”
And this point here is what brings us to our ultimate point of why this time is NOT different. Like the brilliant quote from Buffett state:
“Like most trends, at the beginning, it’s driven by fundamentals, at some point speculation takes over. What the wise man does in the beginning, the fool does in the end.”
If you dissect this tech rally, to us, the fundamentals of lower rates driving higher attractiveness for growth stocks occurred in the second half of 2015. That’s when the wise started to pick this up.
We remember vividly the stories of the FANG being born back in 2015 with Facebook, Amazon, Netflix, and Google trashing the rest of the market in H2 2015 when the market materially underperformed. Fundamentally, the global growth outlook deteriorated with bond yields hitting a new low in early 2016. To those that picked up on that trade and made a calculated risk/reward analysis on the asymmetry of those 4 growth businesses, kudos to you.
But are the people chasing the current tech rally the “wise”? We don’t think so. The reason being that much of the current rally has been driven by massive retail participation. And it’s not just plain old simple stock buying that’s causing the fervor, it’s options.
As SentimenTrader brilliantly puts it in the tweet above, since the start of the COVID pandemic, retail traders have been buying a massive amount of call options.
And the reason for this massive retail participation is thanks in large part to COVID-19. It’s really a perfect storm in the making:
- Mandatory stay home order by local governments (more freedom to day trade).
- Zero commission brokerage houses like Robinhood that sells your trades to quant funds like Citadel.
- Massive stimulus checks from federal governments to stem the decline in wages.
- And of course, the most key ingredient of this, stocks going up.
Without the last variable (stocks going up), retail participation wouldn’t be so high. It’s a case of price driving price narrative that’s what’s causing this high level of participation. And like the great saying from JP Morgan states:
Nothing so undermines your financial judgment as the sight of your neighbor getting rich.
And if it’s so easy, my neighbors can do it, why can’t I?
But this type of extreme sentiment can’t last. And as we have all learned in the past market cycles, fundamentals do not determine when a market will pop, sentiment does. And we have never seen such extreme exuberance from retail participation as we have in this current market cycle. Here are some signs if you really must know.
Evidence 1: Buy companies you know right?
Evidence 2: 20% a week is easy.
Evidence 3: Stock splits = stock prices going up (remember 1999-2000?)
(P.S. He called Tesla a “technology” company.)
Evidence 4: Humble brags?
We have a much longer list of these, but these were some of the most outlandish things we’ve seen. In addition to public market evidence such as these, we also have a compilation of private messages we’ve gotten from friends and associates in the last 3-weeks noting how much money they have made trading options in Tesla and Apple.
In fact, one former high school classmate noted to us that he was going to become a full-time day trader because he was making an “easy” $5,000 a week. And when we inquired about how he was to achieve such marvelous returns week-in-and-out, he went on to state that it’s proprietary.
Oh, I guess we can only be left to wonder how he was able to do it.
Trees don’t grow to the sky and the juxtaposition of growth stock valuations and low-interest rates will be the downfall for the “fools” at the end while the wise have already benefited.
So this time is not different. And to those people that tell you this bubble may continue a tad bit longer, it’s like the meme where the dog sitting in the burning house is saying, “this is fine.”
No, it’s not fine.
HFI Research, #1 Energy Service
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Disclosure: I am/we are short AAPL, TSLA, FB, GOOGL, AMZN, NFLX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.