Sir John Templeton once said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” He was describing the mismatch that often arises between human emotions and investment fundamentals. Since many investors overreact to both good and bad news, this can potentially create enormous opportunities for those who hold a different perspective.
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Last March when a global pandemic was first declared turned out to be a fantastic time to invest precisely because the world was so scary and uncertain. Indeed, while there was much to worry about, the degree of pessimism was so extreme that it set the stage for attractive returns as the fundamentals for many businesses turned out to be much better — or less bad, depending on your perspective — than many had feared.
Similarly, bull markets tend to end when no amount of good news can satisfy investors’ increasingly lofty expectations. The Japanese and dot-com bubbles of the late 1980s and late 1990s, respectively, present two of the most notable historical examples of market sentiment reversals. In 1989, Japan accounted for more than 40 per cent of world stock market capitalization, while the land under the Imperial Palace in Tokyo was reportedly worth as much as the land in the entire state of California. In the late 1990s, a domain name was all you needed to raise capital, as so-called new economy companies such as Pets.com went public, trading at lofty multiples despite weak (or non-existent) business plans.
In both episodes, the key to success for investors was to avoid the most dangerously overvalued areas of the market. Much easier said than done. But when the bubble bursts, it’s not so much what you own, but what you don’t own that makes all the difference.
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By some measures, valuation dislocations today are near all-time highs — even after the recent correction. From 2018 to 2020, the valuation gap between the most and least expensive shares ballooned, but the coronavirus pandemic pushed things into ludicrous mode and, by the end of December 2020, the gap was the widest we have seen in more than 30 years investing in global markets. Some of the most pronounced examples of this divergence include the divides between growth and value stocks and U.S. equities and the rest of the world.
Some of these valuation differentials make sense — up to a point. All things being equal, a faster-growing company should trade at a premium. As longer duration assets, growth companies have also benefited more from historically low interest rates than their value peers. There is also no denying that many of the businesses that entered 2020 as market leaders, such as U.S. technology shares, have been clear winners throughout the pandemic so far. Meanwhile, many of the companies that started the year as market laggards, such as bricks-and-mortar retail, may never recover. Therefore, a bigger gap between the haves and the have-nots was to be expected. Nevertheless, many of these dislocations far exceed anything that differences in fundamentals — or low interest rates for that matter — can explain.
This year, we’ve also started to see clear signs of sentiment shifting from optimism to euphoria. Notable examples of the kind of speculative froth that tends to precede a valuation-driven correction include an overheated initial public offering market, the special purpose acquisition company craze (now with a celebrity component), a spike in retail trading (supercharged by options), the continued rise of cryptocurrencies and the infamous GameStop saga. The jury is still out on whether the peak of this euphoria will be marked by the recent sale of a piece of digital art (or non-fungible token) for US$69 million or the launch of BUZZ, the new exchange traded fund taking its cues from social media and being promoted by Barstool Sports founder turned celebrity day trader David Portnoy.
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Leaving these recent events aside, perhaps even more meaningful — and sobering — is the fact that, at the end of March, there were 60 companies in the S&P 500 trading at more than 10 times revenues. This number has more than doubled from the start of 2018 and has surpassed the previous high set during the dot-com bubble when 39 companies traded at more than 10 times revenues. And these figures don’t even include major tech initial public offerings from 2020, like Unity Technologies, Palantir Technologies and Snowflake Inc. (all software companies), which traded at 36 times, 39 times and a staggering 110 times revenues, respectively, at the end of March. Just to put these numbers into perspective, Microsoft Corp. peaked at 29 times revenues in December 1999 (a valuation that it took nearly 17 years to grow into) and traded at a median of seven times revenues over its history.
While it’s certainly possible that many of these companies will turn out to be great businesses — one might even become the next Microsoft — it seems unlikely they will all deliver the type of growth and profitability needed to match investor expectations given current prices. For those that fall short, the punishment is likely to be severe, as it was for Japanese stocks in the 1990s and technology shares in the 2000s.
It’s easy to conclude that current dislocations appear unsustainable. What’s far more difficult to predict is exactly when they will unwind. Former U.S. Federal Reserve Chairman Alan Greenspan famously popularized the phrase “irrational exuberance” in 1996 — several years before the U.S. market peaked. Even with the benefit of hindsight, it’s still not clear precisely why the Japanese and dot-com bubbles burst. But trees don’t grow to the sky. Eventually, all bubbles collapse under their own weight when it becomes clear that underlying fundamentals can’t support sky-high prices.
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While it’s too soon to tell, this process could already be underway. Following the release of positive vaccine trial data in November 2020, value shares have outperformed growth shares globally by nearly 17 percentage points and U.S. shares have lagged the rest of the world. Bond yields have also jumped on the back of inflation fears, causing a de-rating in shares, whose valuations were based on a seemingly perennial lower-for-longer scenario.
If history is any guide, it can be an ominous sign when the lead steers begin to change direction. Look no further than the share prices of Unity, Palantir and Snowflake, which were heading to the moon last year and are now each down around 40 per cent from their peaks in December 2020 and January 2021, having erased billions in market value.
So what are investors to do? For starters, instead of worrying about trying to find the next Microsoft, now is the time to make sure they’re not holding the next Pets.com.
Chris Horwood is an investment counsellor at Orbis Investment Management Ltd. These views are those of the author and not necessarily those of the Canadian Investment Review.