Before we get started, a brief link to some new Informed content…
Are you worried about inflation? Are you worried about increased natural disasters? If so, have you updated your home’s replacement value to account for the increased risk of demand surge? I thought not. Take a look and speak to your insurance agent afterwards or reach out if you need help.
If there’s one thing this blog is good at it’s calling out the obvious…even when it isn’t obvious to most others. My sports predictions are a litany of teams that screen as obvious favorites but are ignored by the broader public. Calling out insuretech valuations when the broader market didn’t want to hear dissent. Reminding people there isn’t enough reinsurance capacity to fund every startup’s dreams.
There tend to be common blind spots the consensus holds that keep them from recognizing the emperor has no clothes. One is popularity. People don’t want to pick the Bucks or Virginia to win. They want to pick the Lakers and Duke.
Another is fear. People don’t want to look stupid. If you pick the Lakers to win and they lose, ah, well, so did everyone else. People would rather fail with others than succeed on an island. I don’t mind public failures. If you play enough hands, some will go terribly wrong. But if you play in fear, you won’t win as much over time.
One other is persistence. The cycle of a bubble is those who are ultimately right in their bearish analysis usually get run over early and are dismissed as irrelevant. By the time things get truly out of control, there are no credible bears left and the average person has gotten used to the absurdity and forgets it exists.
Plenty of smart people knew there was a housing bubble. Few were willing to act on it because they had been burned fighting it already or they didn’t feel they could get the timing right.
If you had been in a coma for five years and only first heard of bitcoin today, what would you say? It’s nonsense, right? It’s only because you have seen it survive being called nonsense for so long that you accept its legitimacy.
Finally, there is greater fool theory. Many players know they are playing a Ponzi scheme, but they are confident they can sell to someone else before the house collapses. This approach can be quite rational at times, even if it is highly volatile.
Making A List
OK, so what is the point of this post? It isn’t to discuss why these oddities happen. The point is to call out as many obvious, but ignored anomalies as I can. I left some off for brevity, but if you think I missed some, please volunteer more.
When it is late in a cycle, these lists grow long. As always, it is difficult to call inflection points, but it is important to be aware of these risks for they will eventually lose.
I don’t expect a lot of argument about the choices. In fact, you’re supposed to say “oh, that’s so obvious”. Yet, these anomalies exist and they get ignored, largely because they have persisted.
The question is what are you doing to prepare for when these conditions change? As I’ve discussed before, you typically don’t have to be early to get it right, but you do have to know what you’re looking for.
Apple and Other Mega Tech Stocks
Apple is a great company. It is not worth $3T. That’s dumb. The same can be said for Amazon, Microsoft, et al. There is a good chance the stocks go sideways (or down) for a long, long time. Doesn’t mean the EPS won’t grow, but the starting valuations are so high, that the market caps won’t grow.
Microsoft took like fifteen years to return to its 2000 bubble high. Intel and Cisco still haven’t made it. Even non-tech names like Walmart took eight years to hit new highs. Coke needed 15, Home Depot 13, Pfizer finally got there this year. l could go on.
The mega caps are a terrible place to be for the next five years.
Highly Speculative Stocks
I didn’t mention Tesla above because, while it’s cap is large, it’s earnings aren’t and they may never be. Even if they are someday, the stock price is indefensible. If they’re not, remember Amazon and others went down 90% in the tech bubble. Why can’t that be Tesla?
Same goes for the glamour IPOs whether in EV, cloud, or whatever. Not saying the companies won’t do well, but the stocks won’t.
And of course, the meme stock game will end. Who is going to buy AMC when the Apes sell? It won’t be a growth investor. It will be a vulture type who will calmly look at the future of movie attendance, the level of debt, fixed expenses, and realize how hard it will be to generate a profit.
That probably looks like 4X best guess EBITDA. I don’t have financial projections, but I’m going to guess that’s down 90%, maybe more.
Low Interest Rates
If we were playing the Feud here, I would think “low rates” would have to be the number one answer for most obvious anomaly. It’s utter insanity that ten year debt is under 2%. That implies close to zero economic growth under the old saw that the ten year should approximate nominal GDP.
If we think real GDP will be 2-3% and inflation will be 2-3%, then the ten year should be about 5%. If you’re worried about inflation, you can certainly argue for a higher number.
The only way to argue for 2% is to assume a recession or that the Fed will continue to grossly manipulate market rates for another ten years. That’s it. Otherwise, rate levels are stupid.
Low Credit Spreads
Perhaps worse than risk free rates are risk spreads. Long term high yield debt yields under 5%. Yes, high yield credit spreads are at essentially record lows too. Why? Again, because the Fed is manipulating markets to prevent defaults. When that normalizes, spreads probably go from today’s 3% to above 5%. If things get bad, they could go to high single digits.
What does junk debt look like under 5% inflation, 7% credit spreads, and say 2% real rates? That’s 14%, nearly triple today’s yields. By the way, many bond buyers use leverage to get returns equivalent to stocks.
So if you’re borrowing 1/2 or 2/3 of your purchase and junk bonds decline 25%, you lose more than 50%. By the way, your margin gets called well before that so you can’t earn your way back out of your hole. It’s game over.
Why would anyone own junk bonds with leverage today? Great question. By the way…lots of insurers own lots of these bonds effectively with leverage given their business models.
You know what else benefits from low rates and low credit spreads? M&A valuations. I never thought I would be able to say “I remember when companies used to get bought at 6-8X EBITDA” and have the youngsters think I was a boomer.
But when regular old, boring companies are sold, they’re now more likely to be at 16X EBITDA than 6X. How does this make sense? Oh, it doesn’t.
This too shall pass, but, when it does, there will be gigantic goodwill writeoffs as well as some distressed equity raises by buyers who can no longer pay off the debt they used to fund their acquisition splurge.
If anything has a chance to beat low rates as #1 on our board, it has to be bitcoin. It only has value because people think it has value. While you can say the same thing about gold, at least I can look at my gold and make jewelry out of it.
Do a thought experiment with me. If you went to a remote island for the next year, and, when you came back home, bitcoin was down 99%, would you be surprised? If the answer is no, then it has no intrinsic value.
Does that make it inevitable it goes down 99%? No, but given few people would be surprised by my scenario, bitcoin is a perilous asset to own.
And if you can’t value bitcoin (or other crypto coins), you obviously can’t value NFTs since they are essentially derivatives of cryptocurrency. I have written before about how there can be some collectible value for NFTs, but that is all they are – collectibles. And collectible crazes typically perish with the bull markets that birthed them.
The Common Thread
If you haven’t figured it out by now, everyone of these unsustainable conditions is caused by the same underlying condition. Too much money chasing too few goods combined with no fear of default. Both of these conditions were obviously caused by the Fed.
If the Emperor has no clothes, it’s because Jerome Powell took him to a nudist colony.