Wednesday, 22 July 2020

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'New Age' boom: Danger could be lurking as the sharemarket's great divide gets bigger

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The coronavirus pandemic seems to have accelerated a longer term trend in sharemarkets, exaggerating a pre-existing divergence between "growth" and "value" stocks.
It has been increasingly evident that sharemarkets have become bifurcated, with "New Age" technology and media stocks performing better than traditional industrials or resource stocks and a handful of the "mega techs" starring. Those disparities in performance have become significantly greater since the onset of the pandemic.
Wall Street's divide between "New Age' stocks and more traditional companies is getting bigger.
Wall Street's divide between "New Age' stocks and more traditional companies is getting bigger.CREDIT:BLOOMBERG
Since the market’s initial bottom as the threat of the pandemic became obvious in late March, the S&P500 (which includes the large-cap tech stocks) has risen 46 per cent. The technology-laden NASDAQ has climbed 56 per cent. The "FAANG+" stocks – Facebook, Apple, Amazon, Netflix, Google and other big techs like Tesla – have soared 83 per cent.
That’s not an entirely new phenomenon but an acceleration of a trend.
According to Morningstar research, for the year-to-date large value stocks have underperformed large growth stocks by nearly 23 per cent. Over 12 months the performance gap is almost 25 per cent against a five-year average of 8.43 per cent and a 10-year average of 5.22 per cent.
That’s not the long-term historical norm, where value stocks have traditionally out-performed growth stocks by double-digit percentages.
That norm has, however, been overturned in the past decade – the decade since the financial crisis – to the point where the disparity in performance is as wide as it has been since just before the dot com bubble imploded in 2000.
The obvious explanation for the break from the past is the adoption of novel and unprecedented policies by the world’s key central banks.
Massive infusions of liquidity and ultra-cheap credit have forced investors to take increasing risks, encouraging/coercing them to chase the stocks that hold some promise of generating acceptable returns without pricing in the risks.
Famed author Michael Lewis (Liar’s Poker, The Big Short, Moneyball, The Blind Side, Flash Boys, The Fifth Risk), writing in February 2000 - a month before the tech stock bubble burst – provided a sharp insight into the investor psychology of those times.
"To be desirable an internet company must be ever so slightly unknowable," he wrote.
"It must remain forever in a state of pure possibility."
Most conventional stocks can be conventionally analysed by discounting their future cash flows by a risk-free rate, plus a risk-premium that reflects the investor’s assessment of the possibility that the cash flows won’t meet their expectations.
When the risk-free rates – generally the long term bond rates – are near zero, or even negative, and equity risk premiums are compressed by competition because investors are all chasing the same returns from the same investments, stock prices will rise. Investors will accept the lower returns for greater risks because they have no positively real-returning alternatives.
Even if the historical relationship between growth and value stocks isn’t restored, the current acceleration of the divergence in their pricing could easily, and violently, be narrowed if there were kind of shock to investor confidence.
Tech stocks, because their upside isn’t and can’t be defined or capped, meet the Lewis description of being "slightly unknowable" and having "pure possibility."
Macquarie’s global co-ordinator of its equity strategies, Viktor Shvets, has an interesting, and perhaps controversial take on the out-performance of the tech stocks.
If the risk-free rate is zero and the equity risk premium is also around zero, what is value?
The answer, he said in a note issued on Wednesday, is infinity!
Technology and financialisation, he said, had reduced risk-free rates toward, or below, zero while central banks’ intolerance of volatility had compressed equity risk premiums, resulting in a sustained fall in the cost of capital in most jurisdictions.
"At that point most projects become viable and, as (traditional) corporates scramble for deals that yield any meaningful return, the pool of viable opportunities diminishes, forcing an even more aggressive competition, driving both cost of equity and returns ever closer towards zero."
It is, as he said, a vicious cycle.
His explanation for why tech stocks appear to defy gravity is predicated on a transition from the Industrial Age to the Information Age and a less capital-intensive, less capacity-constrained, less labour-intensive era.
New economy businesses have, he argued, near-infinite scalability whereas the value of companies that rely on generating profits from traditional tangible assets will be steadily de-rated.
With a surplus of capital and therefore very low costs of capital, and marginal costs and pricing falling towards zero, any company that appears to have the ability to defy the "gravitational forces" of excess capital and suppressed business and capital market cycles is, he said, rewarded with an almost infinite valuation that is amplified by the near-zero cost of money.
Author Michael Lewis says for tech companies to be desirable they need to be 'somewhat unknowable'.
Author Michael Lewis says for tech companies to be desirable they need to be 'somewhat unknowable'.CREDIT:BLOOMBERG
Fundamental structural changes in economies and markets – the shift from the Industrial Age to the Information Age – are, if Shvets’ thesis were to hold up, being overlaid by the unconventional monetary policy settings in the post-crisis era; settings from which central banks appeared to have no exit route even before the pandemic.
The pandemic, which has injected massive doses of new ultra-cheap liquidity and credit into financial systems and economies, is amplifying and accelerating the long term trends and causing investors to chase the stocks with the most amounts of "pure possibility."
It is impossible at this point to put a ceiling on, for instance, Amazon’s long-term potential, or Facebook’s or Tesla’s or Google’s or the myriad of smaller tech stocks who might not have much in the way of earnings or cash flows but do fit the description of having potential that is "slightly unknowable," or even completely unknowable.
The moment those stocks, priced for something beyond perfection, become knowable – the moment any limit to that potential can be discerned and they can be assessed more conventionally – of course, their valuations will plummet.
If Shvets were right, however, there would be no mean reversion. The relationship between value and growth stocks wouldn’t return, as it did in 2000, to their historical norm, with the companies with strong balance sheets and cash flows positively re-rated and the tech stocks without them de-rated.
Even if that long-term thesis were correct, however, it doesn’t necessarily mean that the market will get the pricing of value and growth right in the short term.
It is quite conceivable that investors have been too harsh on value stocks and too optimistic and too enthusiastic about growth stocks.
Even if the historical relationship between growth and value stocks isn’t restored, the current acceleration of the divergence in their pricing could easily, and violently, be narrowed if there were kind of shock to investor confidence.
An abrupt realisation in the US, for instance, that the impact of the pandemic will be longer and more painful than they currently expect could have that impact on a market which, thanks to the big tech stocks, is pricing in a very bullish future, one of pure possibility rather than the current gloomy pandemic-disfigured economic settings.

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