More stimulus and liquidity may prolong euphoria, but further rise in prices hardly rational

Darius Svidleras
Investment Portfolio Manager
 

• Investor euphoria towards specific equity names creates irrational behavior in the market;
• New round of government stimulus and central bank interventions may prolong short term rally in financial assets;
• Decline in earnings, risk of further COVID-19 lockdowns and potential worsening of economic situation – all indicate that caution should prevail; 

In previous reports we have already discussed that major reasons driving rally in financial assets after COVID-19 crash in early spring are related to creation of abnormal amount of new liquidity by central banks and desire of new investors to enter the market and start investing, especially after they have received extra funds granted by the governments. 

In addition, with economy becoming reopened and received government stimulus being spent, we are also witnessing at least short-term improvement in separate macroeconomic indicators, such as retail sales and others. This creates additional confidence and even euphoria among market participants that equity rally may continue for much longer period of time with perception that global economy would be able to return to pre-crisis levels shortly.

US retail sales ex autos and gas

Source: Bloomberg

As a result, in separate equities rather irrational market behavior is being observed. For example, Tesla which has less than 1% of global automotive market share has increased by more than 400% since late March at one point reaching market capitalization of more than 300$ billion, which is more than 10 times higher than their sales, which actually declined last quarter, and almost surpassing capitalization of Toyota, Volkswagen and Honda (three largest carmakers in the world by sales) combined. Another example is newly created company Nikola, which plans to become Tesla competitor but only in trucks. Company literally had zero sales, but investors were already willing to value it at $30 billion. And these are just a few examples from one specific industry to illustrate observed irrationality.

Market capitalization of selected carmakers
Source: Bloomberg

Same relatively unwarranted optimism can be observed in largest companies in the world such as Amazon which gained from massive increase in e-commerce after the start of COVID-19 crisis or Apple which had higher sales mostly due to people willing to spend stimulus money on new iPhones, iPads or other products of the company. With share prices of these companies increasing by more than 100% since March¹, both having more than $1.5 trillion capitalization and valuation as measured by price to earnings of 34 (for Apple) and 148 (for Amazon), investors at current levels are betting that these enterprises would continue showing phenomenal results in the future as well. In rational world it is only possible if either there would be very strong economic recovery for years to come, or if these companies would become complete monopolists in their industries. Both results are unlikely. Somewhat similar reasoning can be applied and to other major tech giants.

Performance of mega cap tech equities vs S&P-500

Source: Bloomberg

So with such extreme positive performance in popular technology and internet related names what is happening recently is that those companies are driving positive returns for indexes almost singlehandedly and concentration of these names is becoming rather extreme. To put things in perspective, combined market capitalization of just six companies – FANMAG² is larger than capitalization of all companies included in main German, French, UK, Spanish, and Italian indices combined. Does it make sense? Again only if we believe that these companies become full global monopolists or importance of mentioned countries in global business affairs will significantly decline in the future. Both outcomes are unlikely.   

Capitalization of FANMAG vs European indices

Source: Bloomberg

But looking at other industries and companies, business conditions do not look particularly bright. According to Refinitiv,  total decline in revenues for companies which have already reported second quarter financial results in S&P-500 index was -10.4%, while earnings dropped by 33.8%. So far it is expected that next quarter earnings would fall by another 23%. And these numbers even include technology companies which still managed to show positive growth, otherwise results would be even worse. Not surprisingly that equity prices of most severely hit sectors, such as energy, financials, industrials or real estate are still 15%-35% below their levels at the beginning of the year despite all stimulus and liquidity. 

Revenue and earnings growth

Source: Refinitiv

Global equity sector performance since start of 2020

Source: Bloomberg

Of course, maybe this time is different and massive problems affecting let’s say hospitality or transportation industry will not affect strongest names like already mentioned Apple or Amazon completely. But remember, 2008 crisis also at first had quite local impact affecting only real estate sector in USA, but after a while it led to economic recessions and financial crisis all around the world. 

That is why we remain cautious and continue to believe that potentially it may still be only a start of economic recession. Such likelihood indirectly can also be observed from unemployment figures. True, that after lockdown has ended and many businesses were reopened, large number of employees was able to return to work. Temporary lost jobs are being gained back. However, what is concerning is that number of permanent job losses still continues to spike, which usually means that companies are starting to prepare for prolonged weakness in demand, thus starting to save costs by reducing necessary workforce to run business.

Unemployment patterns in USA

Source: Bloomberg

Meanwhile in July more developed countries started to register second wave of growth in COVID-19 cases. Spike in cases was registered in Japan, Hong Kong, Australia and more disturbingly for European Union also in Spain. On the bright side, new cases in USA stopped rising by the end of month, and maybe eventually no new lockdown measures would need to be introduced. Unfortunately, nobody knows answer on how situation would progress going forward.

Other positive developments in July were linked to record high EUR 750 billion stimulus package introduced in EU and plan of new stimulus bill in USA in the amount from $1 to more than $3 trillion, depending on the consensus between republicans and democrats³. In addition FED reiterated its willingness to provide as much liquidity as possible to mitigate negative consequences of crisis.

Once again, it is yet to be seen if all these measures would be able to ensure permanent economic recovery and not just short term boost in consumption from another round of population receiving stimulus payments.

However, new stimuli funds may prolong rally in financial assets for at least several more months. 

In July it also started to become more evident that increase in money supply has its costs. US dollar experienced one of the worst declines in last 10 years, while gold reached new all-time highs. This happened mainly due to the fact that investors start worrying of potential adverse consequences from FED actions, such as rise in inflation and loss of purchasing power of US currency.

Summing up, despite the optimism of some market participants, there are still a lot of uncertainties and potential risks that seem to be ignored. However, should those risks materialize, global financial markets may experience significant volatility. Therefore it is prudent for investors to look at the big picture and stick to their long term investment plans.

US dollar index monthly change

Source: Bloomberg

¹Other major technology giants, such as Facebook, Microsoft and Google experienced relatively similiar price dynamics
²Acronym for Facebook, Apple, Netflix, Microsoft, Amazon, Alphabet (Google)
³No consensus was reached yet at the moment of writing