Opinion: Investors Need to be Careful

The US stock market has almost seen a "V" recovery since the outbreak of COVID-19 in March 2020. Investors have been very bullish on stocks. The S&P 500 and Nasdaq have skyrocketed 55% and 70% respectively since March. In fact, the S&P 500 and Nasdaq have started to surpass pre-COVID levels, which may not be justified looking at the current economic climate.

Due to this rally in stocks, the current market value of stocks is much greater than their intrinsic values, thus a strong performance of the S&P 500 and Nasdaq. Most macroeconomic indicators suggest the world economy is struggling, yet stocks have soared. I believe the two primary drivers of this divide in current market value and intrinsic value of stocks is the Fed doing everything they can to avoid a long recessionary period, and investor's misconception of high-growth technology stocks. This gap has led to an overvalued stock market, by up to 10%, according to some Wall Street analysts. Is this truly a bubble? If so, how can investors hedge against it?

The Economy is in Trouble

There are many macroeconomic indicators which may suggest the economy is struggling. The US-Treasury Yield is approx. 0.68%, a strong indicator of the poor health of the US economy, as even the safest investment is returning close to nothing for investors. What's also troubling is that with the issuance and purchase of massive amounts of T-bills, the US debt balance is increasing rapidly. The national debt stands at almost $25 trillion. Some analysts may argue the national debt balance is not too relevant in determining the fiscal position of countries, the US has been in debt since 1790 and has grown to the largest economy in the world since then. However, the debt balance may become more relevant in this climate because China, primarily Chinese banks, own a sizable portion of the US national debt (almost $1.3 trillion). This is a threat to the US economy as trade tensions have been escalating before and throughout the COVID-19 pandemic.

In addition, unemployment levels in the US have not reached this high in years, with up to 15% of the population (50 million) filing for unemployment. The unemployment in July 2019 was 3.7%, which is almost three times lower than current levels. Massive layoffs, shutting down of businesses and bankruptcies (specially in the retail sector) all suggest that the financial health of many companies in the US is not great, hence a rapid increase in unemployment. Furthermore, Gold and Silver prices are near all-time highs- investors flock to gold and silver during times of high-risk and uncertainty. The high gold prices and the highly-valued stock market do not match up. All these macroeconomic indicators should reflect on the stock market, however, a ratio of the total US market capitalization of all publicly traded companies and the national GDP showed that stocks were perhaps overvalued by approx. 50%. Most economic indicators are telling us that the world economy is in trouble. Is there a growth-tech stock bubble forming? Perhaps.

The Federal Reserve's Actions

The Fed is still buying treasury bonds. Why? The Economic Stimulus. Jerome Powell, and the Fed have issued and purchased trillions worth of T-bills, which in turn reduce interest rates and act as a stimulus to the economy as debt becomes cheaper. This is called Quantitative Easing. The Fed has been running this program even before COVID-19, in fact in August 2019 alone, they purchased $20 billion T-bills to replace mortgage securities. Interest rates were already at record-low levels in 2019 (2%-2.5% range), and additional quantitative easing to combat COVID-19 has reduced interest rates to close to 0 (0-1% range). Meaning, many companies, who do not actually need debt, or cannot take on debt, are getting favorable terms.

The Fed cannot necessarily be blamed for the overvalued stock market, as they are trying to avoid an economic catastrophe. However, by continuing to pump money into the economy, without significant costs, is being perceived by investors as license to aggressively invest away. As stated above, the economic situation, looking at real data, is in trouble. However, the stock market does seems to not have felt the effect of COVID-19. The Fed's cash injection into the economy could be compared to an example of when a parent is taking out a loan to buy his child a Ferrari. The child (investors) wants to buy a Ferrari (stocks) and their parent (the Fed) who has a lack of funds (economic downturn), will still do anything to buy them their Ferrari (continuous cash injections via T-bill purchases). How long can the Fed keep this strategy up, with interest rates already close to 0 and national debt balance very high and COVID-19 showing no signs of slowing down, unless one of the six vaccines are approved.

The Fed's actions to save the economy from COVID-19 may actually result in a worse economic situation. Investors continue to invest their savings into highly overvalued stocks, and if a market correction does happen, which it tends to, the setback to the economy would be immense. Investors are having a gold rush to high-growth tech stocks in particular.

Is The Stock Market Overvalued for Tech Companies?

We have seen from Mortgage Backed Securities in 2008 that a gold rush results in catastrophe. For a recessionary period, with a decline of -5% expected in the global GDP, 2020 has seen many IPOs- approx. 180 IPOs will be completed by the end of the year. Compared to previous recessionary periods, such as the 2008 Financial Crisis or the 2000 Dot-Com Bubble, IPOs slumped per year from their previous year. The reason for the slumps was primarily because of an underpriced IPO market during economic downturns. However, the gold rush to high-growth tech stocks has arguably resulted in an overvalued IPO market. This is the worst recessionary period we are in since the Great Depression, with the entire world economy struggling, therefore, one would assume that investors would be wary of underperforming, overvalued stocks.

The majority of IPOs in 2020 have been, and are expected to be, tech companies; HealthTech, BioTech, FinTech, CyberTech, SaaS, etc. There are currently 1.3 million tech startups. All these companies project very high growth potential, with CAGRs up to 50% per year and offer very innovative and effective services- they are great business ideas. However, there is a significant risk in their businesses; they are not making money. Yet, investors remain bullish on such stocks- they might believe that during a time of uncertainty, growth is the answer.

Recently, many tech stocks, not just IPOs, have soared. Over the last six months, the NASDAQ Index (one-year 34% return) has marginally performed better than other indices such as the S&P 500 (one-year 30% return). NASDAQ comprises mostly of technology stocks, which does suggest that companies in this sector have a high demand and have, as a result, performed better. For example, Shopify, an e-commerce company, (SHOP), has achieved almost 175% returns over the last year, despite reporting Operating Margins and Profit Margins of -4% and -3% respectively. In addition, Kodak (KODK), which is traditionally a Photography company, has now ventured into BioTech and Pharma. They have achieved 375% returns over the last year, despite consistently reporting negative Earnings-per-Share (EPS) over the last few fiscal years. These stocks are examples that investors may be overlooking the fundamentals of the business, for its growth opportunity, resulting in an overvalued stock market.

In fact, SoftBank, which is considered a leader in the investing world, has recently decided to sell $14 billion of its stake in its Japanese Telecoms unit for liquidity. This was part of the $42 billion liquidity plan to repay debt and conduct share buybacks. If one of the world's largest institutional investors is picking liquidity and safe returns, shouldn't this be a signal to all investors to be careful?

A great example of companies going for the IPO gold rush is AirBnB. The company disrupted the Hotel industry in 2008. Since its launch in the US, what started off with one property, AirBnB has expanded into more than 150 countries and has more than 2 million properties. AirBnB filed for an IPO earlier this month for a valuation of $31 billion. AirBnB is a great business, its making money and has strong growth potential. The Travel & Tourism industry as been hit the hardest by COVID-19, with a 70% reduction in revenues, and the industry is likely to see one of the slowest recoveries as people may still be cautious about traveling for the next year. Taking into account the direct impact this economic downturn has had on AirBnB's business, some may argue that an IPO may not be too suitable, because logically, it would make sense investors would be skeptical and AirBnB would not be able to achieve maximum value. However, the IPO gold rush, will perhaps meet, or even exceed, AirBnB's valuation expectations.

The gold rush to high-growth tech stocks, which was developing before COVID-19 and now only accelerated, will perhaps result in a bubble bursting. In 2008, everyone rallied towards MBS, and we saw the effects of that recession last more than seven years. Will the gold rush towards high-growth stocks in 2020 result in a similar, or worse, recessionary period? Probably, unless investors realize to hedge their risk against this bubble.

How Can Investors Hedge the Risk of the Overvalued Stock Market Bubble?

My investment thesis is to invest in companies which are making money and generate strong positive cashflows and will continue to do so in the near future. There are many businesses making money, and many of them also have a great growth potential. The misconception that non-technology stocks cannot have strong growth is one of the primary reasons why money-making growth stocks are overlooked. Obviously technology stocks have a greater potential in the future and do have higher growth probability, however, investors cannot invest in these stocks according to their future value, especially in the current economic climate. Investors must look at present which stocks, based on a fundamental analysis, can earn them returns. This is not to say technology stocks should not be invested in. I believe investors must be patient with technology stocks and let them mature further before investing a large sum of their portfolio into them.

An example of a stock which investors could look at is Estée Lauder (EL). The company is a beauty brand and has had strong Earnings-per-Share (EPS) growth despite lockdowns in many countries. EL has specially made a strong comeback in China, which has almost fully-recovered from the COVID-19 outbreak. EL's recover in China provides a great benchmark and makes a strong case for a worldwide recovery in EL's business as many other countries have opened up. Though the recovery will not happen over night, an EPS of almost $6 and good liquidity can give investors hope in this stock during the economic downturn.

In conclusion, investors need to be careful with investing large portions of their portfolios in buying overvalued stocks. The continuous cash-injections by the Fed might be spoiling the stock market and companies looking to IPO, specially high-growth tech stocks. There are clear indicators why the economy is struggling, and the stock market does not represent that at all. In fact, there is a gold rush. Investors should invest carefully into stocks, and avoid joining the herd as it may result in another market-fix, similar to the one we saw in 2008. My belief if to invest in stocks which are making money, have positive cash flows and have a good fundamental business model which is sustainable.

My analysis was done studying the SEC filings of Estée Lauder and AirBnB, reports on general market trends and financial news. If you’d like to see my excel workbook, or have any further questions, please feel free to reach out to me, especially if you have any positive or constructive feedback.

Written by,

Abhishek Khetan

[email protected]

BU 2020 Graduate