“The only reason to be bearish… is there is no reason to be bearish.”
That is the view of Michael Hartnett, Bank of America’s Chief Investment Strategist, as recently expressed in a note to clients.
In our view, there are reasons to be bearish. It just depends which assets one is looking at, and the nature of the bear case being applied.
Take high-flying technology stocks, for example. There is a formidable bearish case for overvalued technology stocks moving forward, and it is only getting stronger by the day.
The bear case has to do with interest rates at the long end of the curve, and the willingness of the Federal Reserve to sit back as long-end yields (the 10-year and 30-year) start to rise.
Picture a seesaw, which is more or less a lever balanced on a fulcrum.
At one end of the seesaw, you have speculative risk appetite. At the other end of the seesaw, you have low long-term interest rates.
When long-term interest rates go down, speculative risk appetite goes up. That is the seesaw at work. If the economy is flat and money is getting pumped in, this logic applies all the more.
When funding is cheap and the cost of capital is near zero — conditions that are often (but not always) present when long-term rates are low — return-hungry investors tend toward one of two responses.
They either seek out lottery-ticket-style assets — with the potential for a large payoff tied to distant future events — or they pay a fat premium for predictable growth assets in a low-growth world, of the sort provided by the cash-rich tech juggernauts (Apple, Google, Facebook, and so on).
The problem is that, if long-term yields start to rise, the seesaw effect goes into reverse.
As long-end yields go up, the case for speculative fervor erodes, because a rising cost of capital makes it harder to fund projects geared 10 or 20 years into the future.
Also as long-end yields go up, the extreme valuations attached to the tech juggernauts become impossible to justify.
Take a market darling like Apple (AAPL) for example, which has inflated valuation issues we’ve discussed before in these pages (though it is certainly not alone):
- AAPL is currently valued at a price-to-sales (P/S) multiple of 7.4x.
- From January 2010 to January 2020, AAPL’s highest ever P/S multiple was 5.2x.
- AAPL’s lowest P/S multiple in the January 2010 to January 2020 period was 2.2x.
When the price-to-sales multiple expands, it means investors are paying more for every dollar in revenue.
It doesn’t mean a larger quantity of revenue, stronger profit margins, or fatter cash flows. It just means investors are willing to value the same results at a higher premium than before.
The price-to-sales multiple for Apple, a juggernaut worth more than $2 trillion, has swollen to astonishing levels not because Apple is growing quickly, but because tech giants are the new safe havens, and risk-averse investors have few other names to buy.
The problem here is that, were AAPL to revert to back to a 5.2x P/S multiple — its top-of-range showing for the prior decade — the stock price could decline almost 30%, even with Apple’s underlying business staying exactly the same.
And were AAPL to revert to a 2.2x P/S multiple — it’s bottom-of-range showing for the prior decade — the share price would register a decline of 70%, even with the underlying business staying the same.
When valuation multiples become inflated by way of investor overcrowding in a low-interest-rate world, it is like pumping extra hot air into a balloon. If the extra hot air is removed, the size of the balloon will shrink — perhaps by a lot — even if nothing else changes.
This is why, in August, we explained how “Big Tech is the Zero-Coupon U.S. Treasury Substitute.”
The idea was that big tech had grown so popular as a parking place for cash, the valuation premium had swelled to the point where share prices were keying off macro developments more so than underlying changes to the business.
To put it another way, the valuation of Apple (and its fellow tech juggernauts) has been so artificially swollen by the low-rate, low-growth macro picture, all one has to do is sufficiently change that picture — by, say, introducing rising yields at the long end of the curve, coupled with real prospects for inflation — to see the valuation multiples for Apple and other big tech names fall, perhaps by a lot.
Because the big tech names have a macro profile comparable to Zero-Coupon Bonds (ZCBs)— in the sense of being safe-haven plays where nearly all the payoff comes at the end — it makes sense to check in on what actual Zero-Coupon U.S. Treasuries have been doing.
ZROZ is the ticker for the Pimco 25+ Year Zero Coupon U.S. Treasury ETF. If you wanted exposure to zero-coupon treasuries — which are like normal bonds but far more sensitive to interest rate changes — you could get it via ZROZ.
You wouldn’t want that exposure at the moment, though, because ZROZ fell more than 21% within the past seven months and looks poised to fall even further.
Why are ZCBs falling like a stone? Because long-term interest rates are rising. The U.S. Treasury 30-year bond yield is at its highest levels in a year.
And why are long-term interest rates rising?
Because the U.S. economy is in growth-and-recovery mode, and fiscal stimulus will accelerate the recovery further via elevated consumer spending, increased business confidence, and a resurgence of commercial lending.
What’s more, we don’t have to wait for evidence of recovery coming in hot; the evidence is already here.
“U.S. retail sales surged in January by the most in seven months,” said Bloomberg on Feb. 17, “beating all estimates and suggesting fresh stimulus checks helped spur a rebound in household demand following a weak fourth quarter.”
“It was the first monthly gain since September,” Bloomberg added, “and all major categories showed sharp advances.”
Consumers are already spending again, and the next big round of stimulus — $1.9 trillion worth — hasn’t even hit household bank accounts yet.
Then, too, as we explained earlier this week, America is winning the vaccine race — and evidence is mounting on that front as well.
“COVID-19 vaccine manufacturers and U.S. officials have accelerated their production timelines and signaled that the spigots are about to open,” said Bloomberg on Feb. 18, “providing hundreds of millions of doses to match the growing capacity to immunize people at pharmacies and mass-vaccination sites.”
If the pace of vaccination soon doubles — to more than 3 million Americans per day — confidence will increase on that front, too.
And speaking of confidence, how about this: “CEO confidence in U.S. economic outlook reaches 17-year high,” a Fox Business headline reads.
“U.S. business leaders expect to cut fewer jobs and a growing number plan to sharply raise employees’ pay in the months ahead,” says Fox Business, “as confidence in the economic outlook surges amid the rollout of COVID-19 vaccines…”
Not only will the U.S. recovery build strong momentum (this is already happening), in our view the extra trillions in fiscal stimulus, at least for the first few months or quarters of 2021, will be absorbed by the U.S. “output gap,” which is roughly defined as the amount of slack between current productive output and maximum productive output.
What that means in plain English is that we are likely to see growth without inflation for at least a little while — or growth with a moderate amount of inflation, in low-enough amounts for the Fed to wave off.
That, in turn, means long-term interest rates will be able to rise further, and the Federal Reserve will be fine with it. Rising long-term rates are not a problem if coinciding with real growth.
The kicker is that all of this is terrible news for Apple, and every other heavily inflated tech stock, or speculative junk name, that is dependent on historically low long-term interest rates to justify a valuation that would otherwise make no sense.
Think of a balloon again — a big tech balloon — filled to near-bursting with excess hot air.
The “hot air” is vastly over-inflated valuation levels (note again the Apple price-to-sales multiple) predicated on the assumption of forever-low interest rates, forever-weak economic growth, and forever-low inflation.
All of those assumptions are short-sighted, and soon enough likely to be proven wrong.
The whole complex of overvalued assets in the market right now — as defined by investors paying too much for cash flows, or pie-in-the-sky future prospects — has the feel of a zero-coupon bond waiting to see its price get hammered by a growth-driven jump in long-end yields (which the Fed will not prevent).
Then, too, an accelerating recovery could be a double-or-triple-whammy for big tech because the prospect for gains in less-overbought reflation plays — where valuation multiples are closer to rational — could further suck capital out of big tech in a rotation for the ages. In sum, this means the best news for the U.S. economy in quite a while (early signs of a robust recovery, based on real vaccine success, with real growth now and inflation later) also means plenty of capacity for rising long-term interest rates — and rising rates could easily trigger a series of cascading bear market declines for tech investment vehicles, whether conservative or speculative, that are priced for yesterday’s low-yield, weak-growth, low-inflation world.