Despite recent market rallies, the outlook remains bearish for investors.

Why the uncertainty?

The fear of correction looms as equity markets have been rising for over ten years in a row and therefore the common sentiment during 2018 and throughout 2019 amongst investors is that it has peaked. Coupled with a soft first half in 2019; long-standing expectations that global economies will grow at a slower rate than in 2018, now seems likely. Concerns surrounding the continued trade war between the US and China and a slowdown in the Chinese economy; justifies the mood. Furthermore, a growing uneasiness of the level of debt already held in company balance sheets heightens the prospect of a corporate credit crunch and the inevitable knock-on effects of limited liquidity.

What is a bull market?

A bull market is the condition of a financial market of a group of securities or trades, such as stocks, commodities or bonds in which prices are rising or expected to rise. The most common definition is a market pattern whereby prices rise 20% from a previous drop of 20%.¹

Why do bull market runs end?

The current run is the longest in the modern era, overtaking the bull market known as the Great Expansion, which lasted over nine and a half years between November 1990 and March 2000. So, what ended the nearest rival of today? In essence, the era of new technology, in the form of personal computers and widening internet access. Investors embraced the advancing mainstream appeal and most importantly accessibility of the revolutionary sector, thereby becoming increasingly eager to profit from these new technologies and in turn driving stock valuations to new highs. Despite the Federal Reserve (Fed) increasing interest rates six times between June 1999 and May 2000 to “soften the blow” off the back of low interest rates, which fuelled the rally to begin with, it was little too late. The over-inflated stock market culminated in the Dot-Com Bubble of 2004 with the 9/11 attacks in 2001 intensifying market uncertainty in the intervening period from 2000.²

Unfortunately, market psychology is the common cause in the modern history of bull market downfalls, as investors seek to leverage and capitalise on social trends and sentiment at the expense of rational valuations.

Tech stocks

These are companies engaged in technology-related business. Although this sector has historically revolved around electronics, software, computer hardware and information technology, the reality is far reaching in the world of today and interacts with a wide range of industries and society as a whole.

There are hallmarks of the Dot-Com Bubble in these tech stocks, whereby 2000-bubble-like valuations clearly exist; however, nearly twenty years on one argument of distinction is that investors today are consciously seeking so-called ‘growth stocks’ as opposed to ‘value stocks’. This argument is viable to a degree, but the belief that tech companies have an ability to be disruptive to provide social change or to advance beneficial technologies again has in part at least a shared utopia of the 1990s, but in a different era. Investors believed the first time around that the internet would make economies radically more productive, this failed to materialise in the late 90’s and the market collapsed.³

Irrelevant of the motive, the outcome may be determined to be the same; equity value becomes increasingly detached from the company’s underlying profits and cash flows. Consequently, stocks could therefore be over-valued in the short-term, depending on your stock valuation principles, with investor sentiment playing a pivotal role in bolstering the qualitative versus quantitative mismatch.

In context, the proportion of companies reporting losses before going public in the US is at its highest since the Dot-Com boom of 2000. In 2017, according to Jay Ritter, a professor at the University of Florida’s Warrington College of Business, 76% of companies that listed in the US were unprofitable in the year before their initial public offerings (IPOs) compared with 81% in 2000 and 38%, the four-decade average. Furthermore, Ritter also explains that in that year, of the companies that went public 17% of tech companies were profitable compared with 43% of non-tech companies.⁴

Macro bubbles versus micro bubbles

Could tech stocks fan the flames like in the 90s and queue alongside the other reasons for market uncertainty? In truth, despite the eye-watering valuations and losses of these stock market giants, many view it is unlikely the situation will evolve into a macro bubble, being the distortion of the entire valuation of the market, as transpired in the 90s.

The rationale behind the confidence is multiple, which in part one could thank the last bull run between 2002-07, The Hot Aughts, which led to the stock market crash known as the Global Financial Crisis (GFC) which lasted for two years and with it left a legacy of greater awareness. Nonetheless, four autonomous observations could justify the buoyancy of micro over macro, being;

• Investors, politicians and policy makers alike are focused on preventing macro market crashes;
• The rising influence of noise traders, whereby investment decisions are based on noise rather than fundamentals. These traders are mainly online who can influence due to their sheer number whilst spreading the risk;
• There is an overhyping of “transformative” technology and grass-roots sales still account overwhelmingly for the lion’s share of retail sales; and
• Unlike the 90s, tech companies are competing with established participants to take market share from them rather than driving to add value. Most importantly, the end-consumer benefits either way.⁵

Conclusion

The catalyst for the end of the current bull run, despite the similarities, it seems may not be due to the technology sector like in the 90s, given the current landscape suggests a gravitation towards containment is more realistic. Nonetheless, it would be cavalier to dismiss outright the influence of these top-tier tech companies, especially given their scale and global coverage and potential impact at company and market levels.

For example, following the first revenue warning to investors by Apple Inc. since 2002 in January last year, more than 9% was wiped off their value on Wall Street, equating to USD75BN. The repercussions was fast and widespread with all major indices dropping in value as the gloomy news surfaced triggering a selling in Asian and European markets. Apple cited weaker growth in especially China as the cause, this led to share prices falling in other companies seen as exposed to Chinese demand such as luxury goods brands with high consumer sales and mining firms reliant on demand for metals, whilst unsurprisingly supply chain providers to Apple were severely hit too. Acknowledging the connotations with China played a big role in the aftermath; it is nonetheless clearly apparent that the markets see high profile companies such as Apple as a litmus test of macro-economic conditions and as such are prepared to respond unapologetically. This is unchartered waters for all players.⁶

Turning to the bigger picture, as mentioned at the outset the US-China trade war is of paramount concern and with still no deal agreed in 'full', fears of disappointment increase in some quarters that the recent truce will subside. Apple already is testament to the impact of China, whilst coincidently or not, some analysts believe tech disputes could trigger a setback between the two nations.⁷

As expected, the Fed increased interest rates in 2018, typical to mature economic cycles, which in itself gives rise to concern as virtually after all Fed rate-hike cycles - recessions, financial crises and bear markets have followed. Unlike history, despite the Fed’s increases the rates are at a record low level for a record length of time, resulting in a record debt burden in the US; meaning there is a greater sensitivity to interest rate increases compared with prior cycles. However, rolling one year on and in contrast to its actions ahead of the Dot-Com Bubble as cited earlier, the Fed cut interest rates three times in 2019 all by 25 basis points to 1.50%; the drop is a strong signal growth is slowing and potentially a tactical manoeuvre to buffer global risks.^8,9 

Aside from the above, other indicators are likely to be contributing to the bearish outlook including the numerous measures suggesting the US stock market is not only overvalued; but more so, when compared against milestone historic market peaks. Even though the tech bubble may be contained to micro levels and not the instigator unlike in the 90s, the concern remains when; firstly, the US stock market capitalisation-to-GDP ratio has the market more overpriced than even the Dot-Com Bubble.¹⁰ Secondly, the 10-Year/2-Year US Treasury bond provides another reliable ‘red flag’ when the spread drops below 0% - a condition known as an inverted yield curve, the fallout every time since 1950 is nothing other than recession.¹¹ The yield curve inverted in August 2019 recording the largest gap since March 2007, whilst anecdotally noting, the 30-Year US Treasury bond fell to an all-time low.^12,13,14 Thirdly, according to Nicole Smith, chief economist at the Georgetown University Centre on Education and the Workforce; history dictates that when US unemployment rates fall below 4%, the backdrop is either “the boom phase just before a recession or just after a major war period.”¹⁵ Rates in September fell to a 50-year low of 3.5% and with no military action of scale, the past default can only be towards recession.¹⁶

Unsurprisingly, professionals are cautious with allocations to equity and commodity markets falling, resulting in an ‘overweight’ in cash, which may even, be as high as January 2009 in the midst of the GFC.¹⁷ Clearly, this solution is not a strategy and the investor will over time aim to re-allocate assets towards investments with no or low correlation to capital markets with a high degree of capital preservation in order to limit contagion and withstand an economic recession or market crash.

Notes

References