Monthly Commentary - We're Still Dancing

Written by Michael Winter | Nov 19, 2021 4:13:14 PM

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WE'RE STILL DANCING

ALL TIME HIGHS EVERYWHERE

“As long as the music is playing, you’ve got to get up and dance….We’re still dancing.” - Chuck Prince, Former CEO of Citigroup in July 2007³

Risk assets rose during the month of October. The Dow, S&P 500, NASDAQ, Russell 2000, and Wilshire 5000 have all recently hit all-time highs⁴. Total US stock market capitalization, as defined by the Wilshire 5000 Total Market Index has added over $8 trillion to its total market capitalization in 2021 through the end of October. This is the equivalent of approximately 35% of US Gross Domestic Product* of roughly $23 trillion⁵. The Wilshire 5000 market cap is presently at an all-time high of over $48 trillion, resulting in a Total US Market Cap to GDP ratio of over 200%, which is the highest level of all-time for the “Buffett Indicator”⁶.

As we write this, there are at least 70 stocks in the S&P 500 that trade for over a 10x multiple of price to sales*. The NASDAQ 100 Stock Index⁷ forward price/sales ratio* recently notched a new all-time high that is over 5.6x⁸. Take a look at the percent of US stocks trading over 10x price/sales as of late⁹….

PERCENT OF US STOCKS TRADING OVER 10x Price/Sales

….and then read this reflection by a CEO who lived through similar valuations during the 2000s tech bubble:

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at [$price x]? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?” - Scott McNealy, former CEO of Sun Microsystems in 2002¹⁰.

In our opinion, easy money as provided by the Federal Reserve continues to power speculation everywhere. The US housing market has been on a tear, with home prices up over 19% over the past year as measured through the month of August¹¹. Notably, US median home sales prices just hit all-time highs of over $400k per home, not seasonally adjusted; if you look at the below chart, we are now more than 50% higher than the peak of the housing bubble in 2007⁵.

With the overall fervor in risk asset valuations, not surprisingly, investment banks have been capitalizing on the market environment with US initial public offerings experiencing an all-time record year. Look at the quote and visual below, with 925 IPOs (including SPACs) already coming to market in 2021 as we write this¹².

“… essentially from a valuation perspective, the year-to-date performance in the indices have really seen tremendous multiple expansion within the markets. So, if you're an issuing client, you certainly like the valuation you can achieve today.” - Elizabeth Reed, Global Head of Equity Syndicate at Goldman Sachs¹³

During the first week of November, the market cap of cryptocurrencies surged to all-time highs, piercing $3 trillion in market value for the first time ever¹⁴. With all the speculation in asset markets, we find the US equity options market ebullience alarming and potentially disruptive to stock markets. Notably, options trading continues to rise to record levels this year. A recent article noted, “By one measure, options activity was on track to surpass trading in the stock market for the first time ever.¹⁵”

During the housing market bubble in the 2000s, the market for insuring home mortgages grew larger than the market for houses. Now, as the above visual shows, the stock options market appears to have become bigger than the underlying US stock market itself¹⁶!

“Derivatives are the Market… Liquidity is distorting the market.” - Cem Karsan of Kai Volatility

Avis Budget Group Inc (CAR) stock rose over 100% in one day on November 2nd, bringing its year-to-date total return to up over 800% on that date. AMC Entertainment Holdings Inc (AMC), which had an up 300% stock move in one day back in January has a total return that is up over 1,500% year-to-date as we write this¹⁷. In our opinion, the options market has caused major distortions in many individual stocks, which has had significant ripple effects on index holdings as well. For those that own a passive position in the iShares Russell 2000 ETF (IWM)¹⁸, did you know that your two biggest holdings are CAR and AMC¹⁹?

PLEASE STOP THE MUSIC

The Federal Reserve continues to maintain 0% interest rates while purchasing $120 billion per month of US debt to support the economy (and we argue, US stocks), including $40 billion in mortgages per month to support the US housing market; the Fed recently announced it will finally begin to “taper”, which means buying $15B less per month beginning soon. The Federal Reserve announced on November 3rd that tapering will begin later in the month. To summarize, the Fed essentially stated the following.

On a monthly basis, they will buy $10 billion “less” in Treasuries and $5 billion “less” in mortgage-backed securities.
The Fed will reduce the current $120 billion per month spending amount, to buying $105 billion per month, with the number falling by $15 billion per month thereafter
Inflation conditions are expected to remain “well into next year”

The Fed has made no determination on when it may raise interest rates. We think the next several weeks will be eventful as the future make-up of the Federal Reserve is at stake. Who will be at the helm when the next rate decision is made? Perhaps, it’s not Jay Powell, but Lael Brainard?

PORTFOLIO UPDATE²⁰

As we approach the Thanksgiving holiday, households with assets (equities, homes, art, cryptocurrencies, etc) have much to be thankful for. As wild and as powerful as the market sentiment has been, we have been pleased with the performance of many of our stock ideas. Our long positions have reported strong results, including Old Republic Intl Corp (ORI) and Bunge Ltd (BG). Interestingly, as part of its earnings day release, Old Republic announced that long-time Chairman Aldo Zucaro stepped down, with immediate effect; as long-time followers of the company, we think this may portend strategic actions at the company. We maintain our long position. We think Bunge will continue to benefit from rising demand in agriculture; it remains our largest position. On the opposite side of the ledger, the short book has been a mixed bag. We have had success in shorts such as in Peloton Interactive Inc-A (PTON), UTZ Brands Inc (UTZ) and Ollie’s Bargain Outlet Holdings (OLLI). However, short positions in stocks trading at over 10x sales, where we have significant short exposure, have been detractors as they have continued their relative market strength.

In summary, we see a highly constructive setup for long/short strategies, and we look forward to continuing our effort and our dialogue with investors as we approach year end.

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