Cracks in the Facade

By David Nelson, CFA CMT

Last week may have ended on a high note but visible cracks in the market façade weighed on investor sentiment. Inflation expectations took center stage as both headline CPI and PPI releases came in well above expectations prompting a modest flight from risk assets. Stocks recovered on both Thursday and Friday keeping losses contained but the raging battle between growth and value continues to dominate both the news cycle and chatter on trading desks.

Growth (IVW) vs Value (IVE) vs S&P 500 YTD

In the end it will be rates that drive the conversation as the first data point in almost any valuation model is the risk-free rate. Central bank policy makers continue to describe any inflation rise or spike as transitory but behind closed doors I suspect the conversation is getting heated. On Friday Dallas Federal Reserve President expressed his concerns speaking at the University of Texas at Austin’s McCombs School of Business.

So far, bond investors seem to be content to go along with the Fed’s official policy and thinking. Rates on the long end of the curve rose dramatically in the 1st Quarter but have stabilized in a very narrow trading range since. The above begs the question: What happens when a reporter at a FOMC conference yells out “the emperor has no clothes?”

Long before the Fed even thinks about thinking about raising the Fed Funds target, we will have a conversation on the $120 Billion per month purchase program. A couple of weeks ago Fed Chair Powell reiterated they aren’t ready to discuss the end of the program. Most analysts agree that once the tapering starts it will take about a year to wind down.

You Can Smell It

Growth investors can smell it coming or at least think they can because rising rates puts pressure on long duration equity a popular term coined in the last 5 years to help explain the blowout in valuations for popular uber growth stocks.

Looking back at the Dot Com Bubble

During the dot com bubble Microsoft (MSFT) had exploded to 32X Sales. Today Mister Softee trades at just under 12X sales, rich by market standards but certainly not expensive in comparison to many popular stocks in the growth universe.

Shopify (SHOP) at its peak traded at 75X sales and today given both growing sales and a stock price down 25% from the high trades at just under 40X, well above some dot com favorites.

Twilio (TWLO) a cloud favorite is up more than 1100% and even after 5 years as a public company isn’t expected to be profitable on a GAAP (Generally Accepted Accounting Principals) basis as far as the eye can see.

The first data point in most valuation models is the Risk-Free rate and at zero, market valuations can and do get blown out. Why can’t the reverse be true in a rising interest rate dynamic? That’s why the conversation around inflation and what could come next takes on such importance. At this point in the cycle its important to look outside your normal sphere of comfort. Stocks that get cut in half from bubble like valuations can still be overvalued. 

The Good News

No market story is one sided and this one isn’t any different. Despite concerns that some parts of the market are showing signs of froth and dare I use the term exuberance, lots of stocks and sectors offer valuations and returns for a reasonable price.

Estimate revisions any investor can love

Earnings estimates continue to rise as analysts are struggling to keep up with accelerating economic activity. At the start of the year 2021 earnings for the S&P were expected to come in around $165. Today that estimate is $186 or up about 8%. If estimates rise another 8% by the end of the year, we’ll be looking at north of $200 or about 20x earnings.  On Friday Goldman raised their number up to $193. I don’t think it will be long for others to do the same.

*At the time of this article some funds managed by David were long MSFT