Rolling bubbles (and anti-bubbles)
“At the root of all financial bubbles is a good idea carried to excess”
- Seth Klarman
Fear, panic, despair, relief, hope, and euphoria. These are some of the emotions driving investor sentiment. Love it or hate it, investor sentiment plays a large role in setting prices in a low interest rate world. In recent times sentiment has pushed prices far beyond underlying fundamentals creating rolling mini-bubbles. As one bubble deflates another one is created as the liquidity tsunami ripples through financial markets.
There has been no shortage of strange market behaviour since the COVID crash in March 2020. Examples include a West Australian nickel miner surging 70% in early 2021 when it was mistaken for another stock in the United States (GameStop) because they had the same stock code and the latter had surged more than 1,000%. In late November, when the World Health Organisation assigned the B.1.1.529 COVID variant the ‘Omicron’ name, the Omicron crypto currency soared 871% in two days. The buying frenzy based purely on its name alone fizzled out and the extraordinary gains were reversed over time. Sentiment, as you would expect, is extremely fragile especially when it disconnects with fundamentals.
However, stock prices often change based on some fundamental reason. But the seed of truth may sometimes be carried too far. For example, when the COVID crisis initially hit disruptive businesses were in vogue and soared to stratospheric heights. Stocks like Zoom Video Communications (ZM) became a household name when its profits rose, and its share price surged 7-fold to its peak in late 2020. Since then, its share price has retraced about 70% despite its earnings continuing to rise. To be clear, ZM has transformed the way we live, and the stock price is still 140% higher than its pre-COVID share price, but its share price volatility highlights the fragility of a sentiment driven bubble.
While the bubble in disruptive stocks was fleeting, the most fashionable thematic now is ESG investing, where companies with green characteristics are embraced while high carbon emitters are considered dirty and shunned. Since the COVID crisis, fund flows into ESG investing have taken a life of their own.
The tidal wave of fund flows into ESG investing helps explain the market’s love affair with electric vehicle manufacturers. Tesla is the most expensive car manufacturer in the world trading on 76.5x EV/EBITDA multiple versus the world’s top 3 most profitable car manufacturers trading at around an average of 9.6x. It would require Tesla to increase its current expected EBITDA 8-fold for it to trade at a similar multiple to the other 3 car companies. For this to happen Tesla would have to generate an unimaginable profit that would be about 60% larger than the combined profits of Volkswagen, Toyota, and General Motors.
While fleeting sentiment can create bubbles and then burst, they can also create anti-bubbles. Stock prices can also overshoot to the downside relative to fundamentals. The ESG thematic has also led the market to shun companies perceived to be dirty. The energy sector has been particularly battered since the COVID crisis. Despite the oil price recovering to pre-COVID levels the share prices of many energy companies have not fully recovered. Currently, their free cash flow yields are very high given their depressed stock prices relative to the high oil price.
Another obsession by the market since the COVID crisis is the rise of cryptocurrencies. Many new investors believe that it provides a better store of value than gold. Like the energy stocks, gold stocks have significantly lagged the gold price since the COVID crisis. While the gold price has held up reasonably well since the crisis the gold sector has undergone a bear market.
When interest rates are low, sentiment can drive a very big wedge between the share price and fundamentals. The hard part is trying to figure out when these rolling bubbles (or anti-bubbles) burst. Sometimes the reversal is very quick as experienced by the Omicron cryptocurrency, which gave back all its gains within 2 weeks. Other times, it may seem like a lifetime for the bubble to pop as Tesla’s valuation has defied all critics.
While we don’t have a crystal ball, pockets of the market are trading at unsustainable valuations and surviving mostly on sentiment. When consensus appears unanimous and everybody is riding the same wave, returns can be ugly when the wave breaks. To help navigate through the rolling whitewash of sentiment, Vertium uses valuation as an anchor to deliver more consistent returns over the long term with a lower risk profile.