Is This As Good As It Is Going To Get?
As the year 2020 will live in infamy for the negative health implications it brought to the globe, 2020 will also be remembered for the most contradicting state of global capital markets which investors have ever seen. As 2021 begins, the S&P 500 Index hit an all-time high of 3,870.90 on January 26th, while the ensuing coronavirus has been exponentially increasing in cases per day (Yahoo Finance, 2021). Reactions from investors have been contradictory as they have been put into a dilemma on the basis of fundamental analysis, ethics, and capital allocation.
Performing fundamental analysis allows practitioners in capital markets to see that there is a sense of euphoric overvaluation in the market despite the lagging performance in the economy. Not only are we facing a pandemic which is still very much a threat to the well-being of individuals, but the economy and capital markets have been artificially supported off the back of monetary and fiscal stimulus from the Federal Reserve. Historically, one of the most sensible gauges of economic growth in the United States is gross domestic product. As GDP has recently faltered and large corporations have continued to snatch up market share, the disconnect between the euphoric sentiment in capital markets and the depleted sentiment in terms of GDP, economic output, and small business failure is as real as ever before.
The stock market is not the economy and their fundamental relationship is further explained in November research letter produced by the reputable global macro asset management firm, Crescat Capital. The firm utilizes a 15-factor valuation model in order to properly gauge the state of equity market valuations in relation to actual performance and economic indicators (Smith et al., 2020). In Crescat’s analysis, 11 out of the 15 fundamental metrics currently sit in the 100th percentile, these astonishing metrics included U.S. Total Market Capitalization to GDP and Enterprise Value to Free Cash Flow Margin Adjusted (Smith et al., 2020). The U.S. Total Market Capitalization to GDP, also referred to as the Buffett Indicator, is an interesting tool when valuing the current state of global capital markets in relation to GDP as historically the two measurements are highly correlated. For the first time ever, in November of 2020, the US Total Market Cap and GDP reached a negative 10-year rolling correlation. This signals that even as GDP struggles, investors have no problem pouring capital into long term assets. According to Crescat, the US Total Market Capitalization to GDP is 170%, equating to the largest ever percentage of equity market capitalization to GDP in the U.S. Since November's research letter the Buffet Indicator has increased to 224% (Smith et al., 2020). The discrepancy in the historical correlation is a result of the massive fiscal stimulus distributed through the United States Treasury and the Federal Reserve. Especially since the transfer of powers in the United States Presidential administration, the Federal Reserve has been vocal on their efforts to properly accommodate businesses through low interest rates (Durden, 2020). The combination of fiscal and monetary stimulus has propelled the United States to navigate throughout the brunt of the pandemic for the well-being of the citizens.. Furthermore, EV to Free Cash Flow Margin Adjusted is a valuation indicator which considers the total value of a company to the amount of cash the company is able to keep on hand for use in case of emergencies or investments. As the liquidity influx from the Federal Reserve has increased total market capitalization, enterprise values have risen in perfect correlation. This measurement indicates that as companies are not converting their assets to bottom-line cash flow, they are still somehow gaining value in capital markets. The situation in 2020 is one where investors must be cautious and work through the uncertainty in capital markets in order to not fall into a value trap.
As investors diligently evaluate the puzzling state of capital markets, markets remain bullish despite the detrimental impact of COVID-19 on individuals and businesses. The situation leaves investors with an ethical issue which leads them to ask, “Why would we invest in a company which is engaging in unethical practices throughout the coronavirus-stricken time period in order to gain a competitive advantage?” For example, investors may consider the recent allegations brought against the FAANG stocks for mishandling of consumer data to be unethical, however their equity valuations are higher than ever before (Durden, 2020). This preposition has left investors with a dilemma of uncertainty and ethics, leaving them to consider more factors for their final investment decisions. Environment, social, and corporate governance, or more popularly known as ESG, has been a popular investing initiative for investors looking for future growth opportunities in an overvalued, uncertain capital markets environment. Notably, as companies with high ESG ratings tend to be more ethically compliant, the trend of investing in these companies has become a top-of-mind and profitable consideration for investors. Equity valuations were already reaching top levels pre-pandemic, leaving investors searching for long term, sustainable areas to allocate towards. COVID-19 has then accelerated the success of the ESG initiative among the investing community throughout 2020. As investors increasingly push off near term risk amid the uncertain environment, sights are increasingly being set on long term, sustainable investments.
Lastly, as investors are considering more factors into their valuation, one may also wonder which asset class best suited to pile in. In an overvalued market, a balanced portfolio protected from the downside and able to take advantage of the upside is ideal. As major indices have topped out throughout January, investors must take a deeper look at what is actually growing in value. According to Visual Capitalist’s Aran Ali, intangible assets are now considered to account for 90% of the S&P 500 index’s value (Durden, 2020). Intangible assets could be considered as intellectual property, data, software applications, artificial intelligence platforms, cloud computing solutions and so on. The capabilities of intangible assets are an area which remains to be fully explored and will undoubtedly be at the center of future innovation in all aspects of global social interaction. However, the overcrowded technology trade in 2020 has been a catalyst in the overvaluation in the market, especially considering the median earnings yield in the tech sector has dropped to its lowest levels since the dotcom bubble of 2000, according to Crescat (Smith et al., 2020). As the technology sector valuations have allowed the major indices to run rampant, further exasperating the overvaluation paradox, the valuations continue to be unable to be justified. The convergence in factors signaling a major correction in the market, specifically to the tech sector has investors looking into precious metals, such as silver and gold (Durden, 2020). Gold, the classic safe-haven asset, enjoyed a meteoric rise during the downward spiral of the S&P in March and has since levelled off (Yahoo Finance, 2021). As investors have switched back to intangible assets since March, the precious metals industry was able to absorb and enjoy profits, as well as further position themselves for the continuing uncertainty.
As 2021 begins with a new administration and new perspectives, investors in capital markets must consider the questions presented throughout the article. Making use of tools such as fundamental analysis, a sense of ethics, and proper capital allocation, the impending market meltdown due to overvaluation may seem like less of a surprise when it happens...
References
Crescat Capital, Smith, K. S., & Costa, T. C. (2020, November). Crescat Capital November Research Letter. Crescat Capital.
https://www.crescat.net/crescat-november-research-letter/
Durden, T. D. (2020a, November 16). Buffet Indicator: Why Investors Are Walking Into A Trap. Www.Zerohedge.Com.
https://www.zerohedge.com/markets/buffett-indicator-why-investors-are-walking-trap
Durden, T. D. (2020b, November 19). The Soaring Value Of Intangible Assets In The S&P 500. Www.Zerohedge.Com.
https://www.zerohedge.com/markets/soaring-value-intangible-assets-sp-500
Bureau of Economic Analysis. (2020, October). Gross Domestic Product, Third Quarter 2020.
https://www.bea.gov/sites/default/files/2020-10/gdp3q20_adv.pdf
S&P 500 (^GSPC) Charts, Data & News. (2021, January 28). Retrieved January 28, 2021, from https://finance.yahoo.com/quote/%5EGSPC?p=%5EGSPC&.tsrc=fin-srch
