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Valuation Frenzy

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Greater fools and FOMO thinking has permeated the stock market. A growing number of obscure firms have rebranded their companies overnight as cryptocurrency and/or blockchain businesses. Some of them were originally in the business of manufacturing iced tea, electronic cigarettes, and women’s clothing. Each company’s share price and valuation surged dramatically.

For example, LongFin Corp. announced last month it acquired a start-up cryptocurrency business with zero revenues. The acquisition was also majority-owned by the CEO of the acquirer. The insider deal catapulted LongFin’s stock price up by 2,600% at one point. In response, its CEO said (emphasis added):

“The fundamentals will slowly show, but this is crazy trading and has nothing to do with the company’s fundamentals.” – Venkat Meenavalli, CEO, LongFin Corp.

This is reminiscent of the late stage of the Tech Bubble. Stock prices of little-known companies soared after announcing their e-commerce ambitions and rebranded themselves as dot.com enterprises. Greater fools and FOMO thinking fueled the bubble until saturation. We all know how that ended.

Late Stage Bubble

The dramatic surge for cryptocurrency and blockchain companies is a symptom of what is happening in the financial markets. Fundamentals don’t matter right now. Introduced to you 4 months ago was a valuation metric referred to as the Cyclically-Adjusted Price to Median Earnings (“CAPME”) ratio. It showed the S&P 500 valued at the 94th percentile (July 2017) looking back 135 years. The current market cycle was comparable to 5 previous bubbles. They all at one point reached the very most expensive decile (90th to 100th percentile range).

In only 4 months, the CAPME ratio has since jumped to the 96th percentile (November 2017). It has a history of rising exponentially after entering this very expensive decile. In the extreme, it rises almost vertically, as illustrated in the graph below.

shiller cape CAPME valuation cycically adjusted price to earnings cyclically adjusted price to median earnings tech bubble subprime mortgage bubble nifty fifty bubble great depression irrational exuberence

We have seen this before and we know how it will end. 2018 could be an interesting year given central banks plan to reverse the flow of QE.

This parabolic rise defines bubbles. It is only in times of frenzy would people pay up for increasingly expensive assets and expose themselves to substantial downside risk. This happens late in business cycles when irrational behavior is highest. Being 8½ years into this cycle with the CAPME ratio now at the 96th percentile, it shows this market cycle is in the late stage of another bubble. Professional investors know this.

BAML FMS fund manager survey tech bubble cash

Fund managers find this market cycle more expensive than the Tech Bubble, which was ironically the most expensive stock market cycle by most valuation measures.

A fund manager survey (“FMS”) by Bank of America Merrill Lynch in November showed a record proportion found stocks overvalued, as illustrated above. This proportion (blue line) exceeded what the same survey found during the height of the Tech Bubble. Though the Tech Bubble ended with a 50% loss over 2½ excruciating long years, FOMO sure looks to be rising given cash levels (yellow line) are falling. I think we all know how this market cycle will end, too. The problem though is timing.

Timing the Market Impossible?

Economies around the world are in much better shape now. The need for emergency money designed to fight a financial crisis has waned. Monetary conditions should tighten given plans set out by the G4 central banks. This is illustrated in the following graph from investment bank J.P. Morgan. By late-2018, it shows central bank money (blue line) that flows into the bond market should reverse to negative. Exiting these unchartered waters will be led by the Fed (beige bars) which ended QE in late-2014. It also began raising its benchmark interest rate in late-2015 and paring its balance sheet in late-2017.

QE quantitative easing quantitiative tightening QQE Fed ECB BOJ JPMorgan JPM JP Morgan interest rates Federal Reserve bank of japan european central bank

QE should begin reversing by late-2018. Beware bond market vigilantes.

The ECB (blue bars) tapered its QE program last April and announced it will cut its remaining QE program in half beginning this January. Its QE program could also end as early as this September as it approaches policy limits. In fact, the minutes of the ECB’s December policy meeting were released last week and showed ECB officials considered a move “early in the coming year” to further reduce the stimulus. The news came as a surprise to the foreign exchange market. Why? The ECB president gave no indication after the ECB’s December meeting that its policy mix could change so soon.

Despite bold announcements that it will keep its foot on the gas, the BoJ (pink bars) quietly began curtailing its QE program in December 2016. In a low-key seminar last month, its governor stated the BoJ will focus future communication on removing its QE program. He said this was important in stabilizing Japan’s banks hurt by abnormally low interest rates. It has also hinted interest rates could rise. In the previous two months, its governor used the term “reversal rate” in two different speeches. The term refers to a low interest rate that is ineffective in stimulating the economy because banks refuse to lend at that rate. There are also practical reasons to end QE: the BoJ now owns more than 40% of all Japanese government bonds. The Japanese central bank also revealed earlier this month its balance sheet assets in December marginally decreased. This last happened 5 years ago.

Summary

Valuations are at an absurd level right now. Make no mistake: we are in a late-stage bubble. Ironically, everyone knows this and will be trying pull their money out at the top of the market. Timing will be the issue and 2018 looks pivotal as central banks play front and centre again. Trillions of dollars of central bank money lifted asset prices over the past several years. What would happen from a withdraw of that money? Bond markets would need to be self-sufficient. New capital would need to enter. This would invite bond vigilantes to return from their slumber. Interest rates would rise. Losses would incur. Volatility should awaken. Are you ready? 

Whether or not you believe a reversal of quantitative easing would impact an extremely expensive equity market, please consult an investment fiduciary before making any investment decisions. Should you be in search of an investment fiduciary, then Meritocracy Capital Partners Inc. would welcome the opportunity to serve as your partner.

Meritocracy Capital Partners Inc. is a boutique investment management firm & portfolio manager that aligns itself with its clients. We build trust & accountability by providing a fee structure driven by performance and by having our money invested right alongside our clients’ money. As a result, we treat our clients’ money like our very own.

We work with growth-oriented professionals and entrepreneurs that seek a value-focused and performance-driven approach to how their wealth is managed. You can reach us at 778-807-8560 or on our Contact page.

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Stock Market Bubbles in Perspective

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