(949) 706-7777

“Tech Crash Echo”: It’s Beginning To Feel A Bit Like 2000

Valuation: While nowhere close to the stratospheric valuations of the dotcom bubble, the trailing price to earnings ratio of some sectors is high. On the basis of the Shiller PE (CAPE or Cyclically Adjusted PE Ratio), the market’s PE is in the 90th percentile for the overall market, of which the large Tech companies are a substantial slice today. Today one of the highest CAPEs belongs to the consumer discretionary sector, of which almost 20% is composed of Amazon.com; which, depending on how we choose to look at it, is really a Tech giant.  Market breadth measures, such as the relative performance of market cap weighted indices versus equal weighted indices also show that the most recent rally has been dominated by a small set of very large mega-caps.  The S&P 500 internet and direct marketing retail sub-index of the consumer discretionary index trades at a forward PE of 45 (Source: S&P 500. I/B/E/S, Bloomberg).

Another important variable to watch is the level of corporate bond spreads relative to the expected “yield” on equities.  Coming into 2000, average high grade corporate bond yields were higher than the forward earnings yields on the broad equity markets, creating a negative arbitrage in the sense that it did not make sense for corporations to issue debt to buy back their equity.  In today’s environment, due to the incredible amount of central bank liquidity and repatriation flows from large corporations, corporate bond yields are still much lower than forward earnings yields, which has indirectly supported buybacks (see below).  However, either because of re-calibration of earnings forecasts, or a rise in corporate bond yields, the yield differential can reverse.  Due to the higher risk and volatility in growth equities, any time the difference between the earnings yield and spreads reaches less than a 100 basis points, I believe that the conditions start favoring a more defensive equity posture. Then, as now, energy and financials underperformed coming into the 2000 crash, but then in subsequent years did extremely well.  Could the recent bear market in crude be setting up again for a bull market in the next few years in energy stocks?

Earnings: Part of the breathtaking rally in risk assets both in 2000 and the last couple of years has been due to constant upgrades of forward earnings, which tends to create a self-perpetuating virtuous cycle of asset price appreciation and further upgrades of earnings forecasts.  Corporate profits as a percentage of GDP had already started their decline coming into 2000, similar to what seems to be happening today.  Operating profit margins currently have not peaked, and have thus created a bedrock of optimism which could be shaken if earnings miss expectations. But as in previous recessions, downward earning revisions are at best coincident with, and in many cases follow large downturns in the markets.  Note that in the current cycle, the large fiscal stimulus from tax cuts resulted in substantial upward revisions earlier this year, so any revisions downwards may loom much larger as the market recalibrates.

Perception of Risks: Both consumer confidence and consumer sentiment statistics (Source: as measured by the Conference Board and Michigan surveys) have reached highs that were last observed prior to the 2000 crash.  With falling unemployment, a tight labor market, high equity prices and low inflation, this euphoria is not a surprise. Tech is where dreams were made in 2000 (before they crashed and burnt for many companies). It is not very different today.  We don’t have to list all the “Unicorns” that have come out of nowhere to be worth billions on day one.  Many of them are bleeding cash, similar to 2000.  Low levels of volatility today, as in 1999 brings out risk taking and animal spirits.  These perceptions can change on the dime as price action scares speculators out of risky assets into safe assets.  From my discussions with other market participants, the real froth this time is in the private markets, which are more levered to low rates and more exposed to illiquidity in periods of stress.

Yield Enhancement Strategies: Both in 1999 and in this cycle, volatility selling for income has been an important ingredient of the market fabric.  Much has been written about the art of selling options to generate almost “free” money by both academics and “smart” money practitioners. Then, as now, these hidden catastrophic insurance strategies which appear “safe” may create large wipeouts as volatility spikes and sets off a cascade of risk management driven selling in a marketplace of transient and fleeting liquidity.

Flows: Even though much of the current rally in equities has been driven by historically high levels of share buybacks from corporations, buybacks in 2000 were not in aggregate as high as they were prior to the 2007 crisis (Source: S&P), which might provide some comfort. What is similar in the Tech sector, however, is that stock price appreciation is the method by which companies are returning capital to shareholders.  M&A activity has seen three major peaks in the last thirty or so years: in 1998, 2007 and most recently in 2016/2017.  In each case the magnitude has reached approximately $500BN -$600BN per quarter (Source: Dealogic).  Also interestingly the share buybacks from corporations has resulted in a net negative new issuance of corporate securities excluding ETFs, i.e. the total amount of outstanding stock has decreased. The last time the net issuance was negative by this magnitude was in the 2007-2008 period.   Note, however, that if we add back the ETFs, which, as we know are a more recent phenomenon, the net issuance looks less negative.  In other words, the demand from passive and ETF investors has been the dominant reason behind the growth in the public equity markets (Source: FRB), and most ETFs have not seen a persistent bear market.  We should also pay attention to the fact that international flows into US equities have been material in this bull market.  The level of low yields in most developed markets outside of the US has until recently made the US a destination for foreign money looking for return.  With currency hedging costs rising for foreign investors, it is a fair guess that some of these foreign flows are likely to slow down.  Domestically, the level of margin debit balances at broker dealers in the US has more than doubled since 2000 (Source: FINRA.org), pointing to increased leverage in the equity markets as well that can be exposed to rising borrowing costs.

Technicals:  No discussion of parallels can be complete without at least a brief mention of the technicals. Considering the large number of systematic and trend following funds in the industry today who follow technicals, some simple, and widely watched momentum indicators are worth a quick look. Trend-following behavior can be roughly anticipated by looking at some simple filter rules, e.g. moving averages of historical prices. Note that in 2000 the Tech sector (using QQQ ETF as proxy) broke below its 50 day moving average first in end of March 2000, and then definitively broke below its widely watched 200 day moving average in the middle of May 2000.  From May to September, it bounced around these averages, and then started a sustained selloff in the middle of September that resulted in a deep (over 70%) selloff over the next year.  In 2018, the first break of the QQQ below its 50 day average was in early February, and the first definitive break below the 200 day moving average was in early October. Only time will tell if the market action of 2000 is repeated or not. It goes without saying that a 70% selloff would be devastating to the bull market mentality in Tech and risky assets in general.  Emerging market assets were not a great place to hide out in 2000, falling over 50% from peak to trough in a span of a year and a half.

Factor returns: This part is admittedly a bit wonkish and for the quants reading this piece.  By my calculations, 2000 (and 2008) were years in which the growth factor initially did very well relative to other factors.  Typically momentum and trend do well when markets break out of local mean-reversion, and the value factor does less well.  While trend has had a dismal 2018 so far, momentum has done ok, though not great.  Value has performed dismally, and chances are that it continues to deteriorate marginally before starting a multi-year rebound not unlike early 2001.

Leave a Reply

Your email address will not be published. Required fields are marked *