A reporter from the USA Today emailed me last week and asked me to interpret the Nasdaq’s ascension to new all-time highs. He wanted to know what was driving the index’s relative strength (as of my writing, the Nasdaq is up ~ 6.8% year-to-date while the S&P 500 and Dow Jones Industrial Average are up only 2.7% and 1.5%, respectively) and whether it was a good or bad sign for the overall market. Below I will elaborate on some of the thoughts I shared with him. I also have a few additional thoughts regarding Friday’s strong rally in the Nasdaq.
The strength in the Nasdaq is clearly a sign that a “risk-on” mentality is back in vogue. Following six years in which stocks surged over 200% higher in nearly a straight line, why are investors suddenly favoring the most-expensive stocks? Intuitively, this might make sense if the economic data were signaling a strong acceleration in growth. But reality is closer to the opposite scenario. In fact, some of the key economic metrics have been so weak (including a preliminary estimate of 1Q GDP growth this morning of +0.2%) in recent weeks that most economists now believe that the Fed will postpone its first interest-rate hike until September or even later. So what’s going on? If growth is not picking up (or even decelerating), why are people piling into expensive stocks?
The market’s meteoric rise from the crisis low in March, 2009 reflects factors other than market economics. The Fed has been expressly targeting stock prices in an effort to prime the economic pump. Each time the market has swooned over the past several years, our trusty central bank has been there to save the day. Over the past six years, we have been conditioned to expect Fed action that will limit our losses at first sign of trouble. This expectation has been reinforced time and time again, to a point that the Fed has boxed itself in and has added to the risk environment. If investors believe that the Fed will stop price declines, then why not risk more to make more? There certainly aren’t returns to be found in bonds and fixed income. It will be very difficult for the Fed to eliminate the moral hazard that’s been created.
According to our internal analysis, investors continue to favor expensive stocks over cheap stocks (as measured by P/E), and lower quality companies over higher quality companies (as measured by credit rating and financial leverage). Tech stocks, generally speaking, would certainly fall into the “expensive stocks” category. As a further indication of the “risk-on” mentality, Barclay’s published a research piece last week entitled “A Great Deleveraging – Why it is happening and what it means for equities”, by Jonathan Glionna, among others. The piece discusses the paradox that leverage ratios among S&P 500 companies are declining even as interest rates are at historic lows. The author suggests that due to low interest rates, the tax advantages of carrying a lot of debt are diminished. Therefore, returns on equity are constrained right now because of reduced financial leverage. The more interesting point as it relates to our topic is this: “Our factor analysis shows that non-financial companies with high debt-to-equity have consistently outperformed over the past 15 years. In addition, companies that are increasing their debt-to-equity ratio have outperformed. In other words, the market rewards high and increasing leverage.” This is nothing new: in a rising market: leverage magnifies returns. But it goes both ways; leverage increases losses in a declining market.
We do not believe it is a coincidence that investors continue to favor both expensive, high-beta tech stocks and companies with high leverage ratios (and therefore higher ROEs). The Fed’s “conditioning” of investors began long ago in the early part of the new millennium when, after 9/11, Greenspan kept rates too low for too long. Investors, both retail and professional, are now simply doing what they’ve been taught to do when the Fed has their back. Rather than prudently taking some chips off the table following an enormous market move, investors are effectively doubling down on vastly more expensive stocks. This is a reflection of a market that has developed an asymmetric risk-reward profile. Why not swing for the fences if the market only goes up and the risks are limited by an overactive central bank? Accordingly, investors are looking for more bang from their investment buck. Technology stocks are generally considered to be the highest-growth, highest-beta, and most rewarding investments during bull markets. So it’s no great surprise to me that the tech-laden Nasdaq is performing so well right now.
Now, what happened on Friday that is given me a case of heartburn? Pardon my rant, but this kind of blows me away. Two mega-cap technology stocks were up huge on Friday. The stocks of Amazon and Microsoft (I own MSFT personally, as well as for our clients) were each up sharply following their earnings reports on Thursday. The combined market-cap increase for these two companies on Friday alone was over $62 billion. Think about that. On one day, just two stocks increased in value by more than 2.5x the largest IPO ever. Is it probable or even possible that $62 billion in value was created on one day? In 1996, at Dow 6000, Alan Greenspan said markets were exhibiting “irrational exuberance.” Eight months later the Dow was at 8,000. Greenspan was correct that stocks were expensive. They then became more expensive. Stocks are looking a bit expensive now. They can easily go higher, especially with the Fed’s monetary support. But wise and wizened investors know that stocks go down and that real returns are earned as much by enduring downturns as they are enjoying the rallies. We are defensive and cautious. We never enjoy downturns, but we are preparing our portfolios and our constitutions. There is no telling how much longer this bull market may run, but he has to be getting tired.
This morning we received news that the economy grew at an anemic pace of +0.2% in the first quarter of 2015. This was below the consensus expectation for growth of +1.0%. While stock futures fell a bit on the news, the reaction remains muted. This is another indication that stocks are being driven by some factor other than the fundamentals. That factor is Fed monetary policy, and we will receive a glimpse into the Fed’s latest thinking later today as the Fed wraps up its 2-day meeting. But as has been the case for several years now, weaker economic data has traders betting that the Fed’s initial interest-rate hike will be pushed out further into the future. Despite the Fed’s removal of the word “patient” at its last meeting, the markets aren’t expecting rate hikes any time soon. According to an article in today’s Wall Street Journal (“Fed Talks, Rate Liftoff Date Walks“, by Spencer Jakab), “In this instance, though, the market really is treating the Fed’s talk as cheap. Futures contracts tallied by CME Group Inc. suggest odds of a rate hike in June are a minuscule 2.1%. They are less than 25% in September and just 55% by December.” In short, we remain mired in the endless cycle whereby investors aren’t reacting to the data but rather to the Fed’s reaction to the data.