In the 1st quarter, thanks to the Federal Reserve’s about-face on interest rate policy, US stocks almost made back their losses from the 4th quarter. The S&P 500 rose 13.4% in the quarter. Technology stocks outperformed the broad market up 16.5% and crude oil traded up a whopping 31.4%. All it took was Jerome Powell to say that the Fed would be “patient” and “listen to markets”, implicitly promising to hold rates steady – greenlighting speculators to enter enough buy orders to make January the best January since 1987 and the 1st quarter the best 1st quarter since 1998.
In this letter, we will lay out the case that while the near-term path of least resistance for equities may be to the upside, it is still a time for caution and vigilance. Markets may continue to rise, and stocks may remain in a low volatility environment, but conditions on balance seem euphoric and characteristic of a late-stage bull market – a time when it traditionally pays to be careful.
This presents a dilemma for conservative investors that have experienced adverse markets before and who are skeptical of the speculative euphorias of the kind that bring leveraged investors piling into the most popular stocks – stocks that trade at already-astronomical valuations. To us, this is tantamount to playing musical chairs.
Venture Capital, IPOs and Tech Bubble Redux
Today’s enthusiasm is manifest particularly in tech stocks. Of all the companies going public, we now have the same proportion of IPOs being done by companies that lose money as there were in the 1999 tech bubble (chart on the next page). The first quarter of 2019 was punctuated by the initial public offering of Lyft, whose shares were offered at $72 and saw their first trade at $87.24. Now Lyft trades at $56.11 (as of the writing of this letter). Lyft is a company that lost $911,000,000 in the 12 months prior to the IPO yet trades at a $23 billion valuation. And as if to taunt stock speculators further, Lyft is a company that loses more money as its revenue grows, and the company discloses right there in its offering document that it may never make money.
Just like in 1999, the Lyft IPO will be leading a parade of Silicon Valley companies to Wall Street. Most of the companies going public today possess an all-too-familiar quality as those IPOs in the dot-com era of 1999: lots of red ink. Those companies’ main positive attributes are that they are the beneficiaries of much of the exalt and fanfare put on by the Wall Street banks’ promotional machines. And when Wall Street is itching to earn fees to place their deals, it can be quite a show.
Wall Street banks love companies that lose lots of money. Why? Because they are perennial customers for capital raising. When you lose money year after year, you need outside investors or lenders to continue pumping money in, and for that you need a Wall Street bank to hype your story for a successful capital raise. Moreover, companies that lose money make attractive candidates for mergers down the road, go-private transactions, or other strategic acquirers. Therefore, Wall Street institutions have an incentive to say nice things about companies that might pay them huge fees in the future. And the financial media, such as CNBC, plays a critical role in promoting the hype and excitement around large IPOs in order to get the public clamoring and stoking their fear of missing out. It’s all about ratings for the media, which means advertising revenue. One can simply watch the media spectacle on the Lyft IPO through a search on youtube.com to see how money and wealth gets transferred from the hands of the many (the public) to the hands of the few (Wall Street, venture capital and company founders).
As the IPO chart above indicates, it is possible we are in yet another venture capital/tech bubble. Let us consider:
1. Venture capital firms, who provide the initial financing for new companies in the tech sector, have been raising larger and larger funds at an increasing pace despite a lack of viable deals. Sequoia recently raised $8 billion, the record for a US venture firm. David Rubenstein, chairman of the private equity firm Carlyle Group, said, “It’s easier to raise money than any time I’ve been in the business.” Too much money chasing too few deals does not bode well for future returns.
2. Middle Eastern investors (through sovereign wealth funds), who are notoriously late to every euphoric investment trend, are all-in on Uber (with over 10% interest) and have even opened offices in Silicon Valley to do more deals. They purchased Carlyle Group at the peak of the credit bubble in 2007 and were anchor investors in Glencore when it IPO’d at the height of the commodity cycle in 2011.
3. Saudi Arabia, the single largest funding source for US startups, has funneled in at least $15 billion since mid-2016. By comparison, China has invested $11 billion in US startups since 2000. If you remove Saudi Arabia from the global funding network US venture capital collapses.
4. In less than 6 months, through successive rounds of venture financing, DoorDash’s valuation tripled to nearly $4 billion, Robinhood went to $5.6 billion from $1.3 billion and Coinbase went to $8 billion from $1.6 billion. This is what happens when there is a surplus of cash underwritten by the Fed – it leads to a shortage of sense.
5. There has been a 10-fold increase in venture stage/private equity investing by mutual funds in just three years. There are now 250 mutual funds that hold positions in private technology companies.
6. Because of quantitative easing and zero interest rate policy, capital has been abundant, but had nowhere to go because the world was in a downturn for a long time, and US economic growth was sluggish. The scarce asset was “growth”. So, any company that showed high top line growth attracted gobs of outside investor money and had their prices run up to astronomical levels.
7. Uber’s new CEO said, “We suffer from having too much opportunity right now as a company.” To help ease its suffering, Uber has burned through $20 billion since it was founded 10 years ago. Private capital (from venture investors, sovereign wealth funds and Wall Street banks) is now tapped out for late stage companies, so Uber will go public soon in order to access the public’s money by promoting all of its glorious growth opportunities. Uber’s IPO may mark the top of today’s tech bubble.
8. When the leading company in the hottest sector goes public, it often reflects a peak in euphoria and excitement and can often present an important inflection point in financial markets. It is important for investors in public securities to remember that, as a rule, insiders sell at the top – when they can get the best price. The AOL Time Warner merger marked the top of the tech bubble in 2000, the Blackstone (the real estate investing company) IPO predicted the real estate meltdown, and Glencore’s IPO in 2011 predicted the top of the commodity cycle. Now Uber, with all its excitement and fanfare, and being representative of companies that develop services distributed through apps, losing huge amounts of money while trading at tens (if not hundreds) of billions of dollars in value, could mark the top of this latest cycle.
An indicator that all might not be well in techland is that most tech stocks trade significantly below their 2018 highs. Moreover, real estate prices in San Francisco and Seattle, two tech hubs, have begun to decline. And financial stocks, an indicator for the strength of the entire stock market, are also showing signs of fatigue (see chart below…the pink line shows bank relative strength (bank stock prices divided by overall stock prices)).
Weak bank stock prices are particularly concerning since 24% of the US economy and 31% of services is in finance and insurance. There is significant pressure to cut fees and recently JP Morgan and BlackRock have already made major workforce reductions. This does not bode well for strong economic growth ahead and may explain why Trump and his advisers have been calling on the Fed to lower rates by 0.50%.
Another disconnect in markets is the conflicting signals between a) stock prices getting back to all-time highs and b) the bond market rallying (signaling slowing ahead). This is notable. The economy wants to slow, and stocks would likely trade down if not for a supportive Fed, but the Fed won’t allow either. Because of Fed policy, corporate share repurchases have become the main source of market liquidity – more than all other sources combined by far. The huge level of buybacks now has many reasons to abate. And peak levels of corporate buybacks has a history of signaling adverse markets ahead, making us even more wary of avoiding today’s speculative areas, and the popular/overvalued companies.
We readily admit that we don’t know the future and can’t predict markets, but the factors we think are important guide us toward caution. We have largely avoided investments around areas with the high levels of optimism we now see in technology and banking and we will continue to do so. There is simply not much value in those sectors. For our long term investments (equities), we think there is a place for 1) gold, which tends to do well when financial assets (stocks and bonds) do not; 2) emerging market equities, which trade at a significant discount to US equities (a price-to-earnings ratio of 12 vs. 17) and have higher earnings growth expectations; and 3) investments in very high quality companies that are currently out-of-favor. Value, by definition, is more likely to be found among the unpopular.
Apart from that we continue to keep equity allocations on the low side of what is allowable. We agree with Mark Twain that speculating in the latest hot trend is usually never a good idea. While other investors chase the tech bubble, we will abstain. Capital is now avoiding some great companies simply because they are not technology companies. We saw this same phenomenon in the late 1990s (another time of excessive government stimulus due to Y2K). At the tail end of the tech bubble, investors positioned in high-quality stocks ( those that had been previously shunned) experienced huge future returns while those playing in techland, or simply the S&P 500 (which was 30% in technology) suffered greatly.
At Highgate, we go above and beyond the typical advisor by doing the hard work of investing and diligently analyzing the footnotes in financial statements -- where many risks are buried in the disclosures. It’s our rigorous analytical process that distinguishes us from the crowd. We work well with sophisticated investors who understand and appreciate our approach, who aren’t chasing returns or the investments du jour, and who value their ability to always speak with us directly when they have questions or concerns.
The advantage of an investment process like Highgate’s is that because our focus is on safety of principal and the value of what we own, we believe we get the double-benefit of having high return potential and carrying significantly less risk. When markets become adverse, we are not likely to suffer the painful declines that those who are trading in the most popular, and most expensive stocks will. And if we can limit declines during tough times, we will have much higher average returns.
Thank you for considering Highgate Securities Investments to help meet your investment goals. We can be reached at 303-968-1230, or by email at email@example.com. You can also visit our website at www.highgatesi.com. We are happy to perform a no-obligation, objective portfolio evaluation for you.
John Goltermann, CFA, CPA. CGMA
President, Highgate Securities Investments