It seems like an obvious point today, but it is important not to confuse genius with leverage. Extreme leverage always seems to be a good idea when it works, but it clearly operates both ways. For years the Fed have denied the fact that super-abundant liquidity and financial repression could pose financial stability risks. In January this year Jay Powell again pushed back on the suggestion that there was excessive valuation in financial assets or a strong relationship between stock prices and interest rates. Of course, the problem with that argument is that anchoring policy rates, short rate expectations and sovereign yields via asset programs is designed to encourage lending and a preference for risky assets.
From our perch there is a clear link between liquidity, leverage and equity prices. Moreover, during phases of expanding liquidity there also tends to be a self-reinforcing increase in margin debt or investor leverage that tends to coincide with a compression in risk premia and volatility. Unfortunately the NYSE no longer publishes the time series on margin accounts. However, the historical data highlight the coincident link between equity prices and margin debt (chart 1). To be fair, the increase or decrease in leverage and liquidity is also correlated to the business and profit cycle and therefore also reflects the fundamentals. However, rather than being independent, liquidity and leverage reinforce the biased expectations of market participants in a self-reinforcing process that tends to exacerbate the valuation of assets to unsustainable levels.
Yesterday we showed a time series of the US Information Technology sector trading at 7 times Enterprise Value to Sales. In addition to the extraordinary level of the valuation that was comparable to the 2000 episode, the non-linear or parabolic nature of the re-rating over the past few years suggests that it has also been driven by emotion rather than rational expectations grounded in empirical reality. To be fair, and as we have often noted, the major US technology companies have net cash on balance sheet and 30% trend return on equity (genuine profits). Nonetheless, the recent phase of “new paradigm, new valuations” has also driven the valuation of companies with no earnings to similarly lofty levels (chart 2).
In our process, the warning signs are; 1) when an equity or asset price is extremely overvalued; 2) when there is a large divergence between price and underlying fundamentals; and 3) when an asset price starts to move in a non-linear or parabolic way. As Cam Crise noted, the tale of Viacom CBS and the associated fall out is instructive in this way. While we do not follow the induvial name or have insight into its earnings prospects, the rapid move from $37.26 at the start of the year to $100 last Monday suggests that price has been driven by something other than simply fundamentals. Clearly Viacom management thought the rapid increase in valuation was an attractive level to raise capital (sell).
To be clear, we believe that liquidity will remain super-abundant and continue to support financial conditions and the strong macro cycle. It is also important to note that not all equities are expensive. We continue to favor a basket of companies in Asia Pacific with strong free cash flow, low balance sheet leverage and strong dividend growth. Ironically, super-abundant liquidity could also continue to support the speculative “new paradigm” stocks. However, the lesson of the past few weeks with the correction in some of these names is that the price pay matters for your future (ex-ante) return. It also highlights the perils of excess, hidden leverage, skewed positioning and beliefs.
About the Author:
Nick Ferres is CIO of Vantage Point Asset Management. Prior to this, Nicholas was at Eastspring Investments, the Asian asset management business of Prudential plc, as Investment Director, in September 2007. Nicholas was Head of the Multi Asset Solutions team and was responsible for managing the global tactical asset allocation of funds for external institutional and retail clients. Before joining Eastspring Investments, Nicholas worked for Goldman Sachs Asset Management as Investment Strategist & Portfolio Manager. He has more than 20 years of financial industry experience. Nicholas holds a B.A. (Hons) in Economic History and Politics from Monash University, Australia, a Graduate Diploma in Economics and a Graduate Diploma in Applied Finance.