Following the initial COVID-19-induced market unrest, teach-heavy financial markets (e.g. the US) have re-traced their initial losses and today, the S&P500 is less than 8 % from its peak. While this could be interpreted as tentative signs of a recovery in financial markets, alarm has been sounded over the growing deviation between this perceived financial recovery and the lack of any meaningful progress in the economy per se. Comments along the line that that ‘the stock market is growing increasingly divorced from economic reality’ are common.
On the face of it, these concerns make sense. The US is currently in an economic recession, and the government’s poor handling of the virus means that the country’s economic outlook looks arguably worse today than it did during the initial market turmoil. However, if we look beyond these face-level impressions, we begin to see that the story is, in fact, more complicated. Indeed, if we zone in on the S&P500, we find that many of the post-COVID-19-gains have been made by gains in tech stocks. In other words, it’s only a handful of stocks that have been the driver of the recent market recovery. If we look at a more tech-heavy index like the NASDAQ100 (up over 6 % from the pre-virus peak), we can see this more clearly still.
This makes for a strange financial recovery. So, what’s going on?
Many explanations have been offered. One of the most common goes along the line that investors have somehow lost their mind and that we’re seeing the start of another Fed-fuelled tech-stock bubble. In the long-term, this might (or might not) be true. In the short-term, this is however puzzling, since stocks should (in an ideal universe) be valued on the basis of the value of their discounted cash flows into perpetuity. At current valuations, this means that many of the highly-valued tech stocks would need to see some rather punchy growth numbers going forward to justify their current valuations. Now, of course, it is possible that investors have been moving their investment horizons forward; valuing companies on 2030+ cash flows and extending these longer into perpetuity to reach these higher terminal values. However, I think this interpretation is (short-term) incorrect.
First, I must confess that I, over time, have grown increasingly uncomfortable with the idea that valuations ‘mean’ anything. I think a strong focus on valuation is very firmly rooted in the value-investing tradition personified by Benjamin Graham and Warren Buffet; a strategy that worked well in the inefficient markets of the mid-1900s, when it was—in many cases—sufficient to read a company’s filings and to crunch some simple numbers to see if a company’s stock was undervalued or not relative to the intrinsic value of the business itself. Over time, this style of investing (real-time valuation) has transmutated into growth investing, where more and more of the business value is expected to be generated in the future, with investment made more on the basis of expected future value than the business’ value today.
Over the time that this transmutation has taken place, we have however also seen two additional developments that have changed the nature of markets:
First, the early successes of successful investors (Warren Buffett included) have given rise to the idea that financial markets offer the economic equivalent of a ‘free lunch’: Put some money into the market and see it grow over time (c.f. passive investing). This attitude has seen more and more investment funnelled into markets (at the expense of other investment venues with longer-term investment horizons, like manufacturing innovation and scientific excellence) to the point, where, today, a large proportion of the social welfare system (e.g. pensions, insurance, savings) have been invested in ‘going-up’ assets like stocks or real estate. With more and more money competing for (increasingly) much-needed gains, the competition for gains have intensified. (This leaves fewer and fewer stocks unturned, washing away the sure gains of value investing and pushing the balance in the favour of growth investing, and, increasingly, riskier assets like private equity.)
Second, at the same time, and because of their increasingly important role as a source of income, financial markets have (ironically) become less free: The more of an economy’s social welfare is invested in markets, the more dangerous any volatility in these markets can become. (We saw the impact of this all too clearly during the Great Financial Crisis and the resultant fallout.) As a result, there is an increasing need for economies to manage financial markets; to engineer away any volatility to safe-guard continued growth. (We have seen this with the increasingly desperate support packages that have been made available to prop up the markets to avoid any virus-associated fallout.) One the one hand, this is the inevitable price that we must pay for the free-lunch mentality: If the social welfare of a country is invested in—and therefore dependent on—continued future gains in financial markets, it becomes an economic imperative to avoid any market corrections (which would be costly). On the other hand, this is (regrettably, but predictably) introducing even more volatility into the markets—for the very reason that they are no longer ‘free’.
Free-market systems are naturally self-correcting because they adhere to the same rules that govern other evolutionary systems (like the competition among genes and their extended phenotypes in a natural environment), where different strategies compete for the spoils as part of an ever-escalating arms race. This type of evolutionary competition favours the exploitation of untapped resources, and as one niche becomes over-populated, another one will bloom in its stead. This dynamic is more stable because it self-corrects, as any emergent instabilities are exploited and deflated as part of the overall process. This ‘blind’ process will not stop even after interference by a ‘seeing’ actor. Instead, any management of the system will introduce new rules to the process, shifting the dynamic in the direction of new optima. These optima—if the process is managed well—can be more preferable than what came before. Often, they are however counter-productive: Because the system is so complicated, any interference is likely to push it in the direction of a less-favourable optimum. This is true of both organisms and stock markets.
Altogether, this is a very long-winded way of saying that valuations are relative: What is considered over- and under-valued will depend on the system and the rules that govern it, and what optima arise as a result of these factors. Without a good benchmark by which to estimate ‘value’, any distinction between under-and over-valued becomes meaningless. Instead, we are reduced to relative terms like ‘more’ or ‘less’ expensive, but unless we compare like with like, this is often a futile exercise. In term of company valuations, this means that we cannot compare different companies (different business models will necessitate different valuations) between markets (different economic systems will produce different optima) or over time (for the same reason). The valuation of a company in one market today will be influenced by very different factors to the valuation of a company in another market at another time.
You might recognise these problems as being similar to inflationary problems, and you’d be right: The study of inflation is much-plagued by the fact that we cannot compare the value of a currency across economies or between time-periods. And without such a pan-market-pan-time-gauge, we cannot compare like with like, and the entire exercise fades into the realm of model-driven interpretation (as opposed to rational analysis). This applies to both currencies and companies.
What makes currencies relevant to the discussion at hand is that a currency acts as a store of value. In the olden days, the coins themselves had value (being struck from metals like gold and silver). Over time, currencies evolved into derivatives of the store of value; being minted from lesser metals, backed by centralised collections of silver and gold. Today, most currencies are backed by the issuer itself; their value being derived from the issuer’s promise that they will honour the value of the issue. As such, the value of a currency is implicitly the value of the issuer’s word and their ability to do good on their promise. This makes currencies hard to value in absolute terms (how do you value the strength of somebody’s word?). Instead, we’re stuck valuing currencies in relative terms, by comparing to other currencies.
Currencies are however not the only store of value in an economy (even if they are often the most liquid store of value). Rather, anything of value can also be a store of it. As a result, economies will see the rise of something that’s called a ‘quasi-currency’; an alternative currency that shows some of the characteristics of a currency (e.g. acting as a store of value, even if its liquidity might be lower). These quasi-currencies can take the shape of everything from real estate to derivatives to precious metals or oil and stocks.
Accepting the existence of quasi-currencies is when the dynamic starts to become interesting: Depending on their popularity, these different quasi-currencies will see different levels of ‘inflation’ (an increase in the money-equivalent-value of the quasi-currency, as a result of a mis-match between supply and demand). These varying levels of inflation accordingly make the quasi-currencies variably good stores of value, since, ideally, you want to store your wealth in a form that grows it (rather than destroys it). This means that the best store of value will fluctuate according to prevailing market conditions and their relative popularity (whatever is commonly agreed to be a good store of value will become a good store of value as part of a self-fulfilling prophecy). In this interpretation, a rise in the relative value of an asset is the result of an inflationary process in a specific form of quasi-currency.
When consumer-price inflation is high, the currency of the economy is devalued: The currency has stopped being a good store of value, and ‘value’ is migrating into other quasi-currencies. (In hyper-inflationary economies, the concept of a quasi-currency is anything that is not the currency per se, like the broken clocks used for barter during the worst days of hyper-inflation in the dying days of the Weimar Republic). In the inflationary economy of the 1980s, the store of value—the quasi-currency—seemed to be gold (the asset that saw the most impressive dollar-gains). In the late 1980s, real estate might have became a store of value (leading to the property boom and bust), and after this fixed income saw a brief period in the limelight (because of attractive dollar-yields), culminating with the fixed-income crash of 1994. (There are circumstantial suggestions that money-flows from fixed income to stocks in 1994 fuelled the first stock-market acceleration that culminated with the dot-com bubble and subsequent crash.)
After the Great Financial Crisis, US stocks seem to have become a de facto quasi-currency, with market gains accelerating in 2013. Today, more and more of this quasi-currency status seems to have migrated to the big tech stocks, and I would argue that the market uncertainties surrounding the coronavirus have exacerbated this process because the tech stocks represent some of the world’s most successful companies, which makes them an objectively good store of value. According to this interpretation, the valuations of this select group of high-performing, super-successful companies is not made with the intent of earning a meaningful return; it is done with the intent of keeping the money safe.
As it happens, money is gregarious, and where money goes, more money will go (as part of the self-fulfilling prophecy I mentioned above). This makes the flow of money (the liquid medium by which one quasi-currency and store of value is transformed into another) into a quasi-currency a self-perpetuating process, and beyond a certain threshold of money-flows, the flows will accelerate. Accelerating flows make the quasi-currency seem increasingly attractive as a store of value (i.e. a good investment, in real-money terms), and this will attract more money, in turn. Ultimately, we are left with a situation where a lot of money is stored in a small class of assets (whose value, in real-money terms, has increased). This could be a bubble if the crowding of money becomes acute enough (as people pile in, not wanting to be ‘left out’, up to the point where the slightest uncertainty about the quality of the store being enough to break the spell), or can be just a temporary blip if the crowding was spread across a larger set of assets/quasi-currencies.
In short, I think the current spurt in tech valuations is due to this process: Just because of the uncertainty of what’s going on in the economy, there is a lot of uncertainty about what will happen to the markets themselves. As a result, money has flowed from more-questionable assets (whatever their objective quality) to (what is perceived) as higher-quality assets. Today, this just happens to be high-performing US tech stocks. Therefore, the ballooning valuations of this basket is not made with the intent of generating a return (that’s just a happy side-effect), instead, it’s made with the intent of safe-keeping. Money might want to be free, but it also wants to be safe.