These bubbles pose risks for advisors seeking to allocate client assets. However, those with the flexibility to make tactical deployments may find attractive opportunities to achieve diversification and growth outside the public markets. While we certainly can’t predict when these bubbles will pop, we can offer data that can help interpret the current environment, as well as plan portfolio allocations.
HOW WE DID WE GET HERE?
Asset bubbles are a more frequent occurrence than economic theory would suggest. One of the most infamous was the dot-com bubble of the 1990s, when companies leveraging the increasing popularity of the internet soared in value. From the beginning of 1990 to its peak in March 2000, the Nasdaq Composite index increased over ten-fold1 before subsequently crashing more than 75% by October 2002.2
We are currently witnessing asset bubbles fueled by cheap money. In the aftermath of the 2008 Global Financial Crisis, the Federal Reserve (Fed) slashed interest rates and kept them low in a bid to stabilize markets and promote economic growth. Low interest rates meant that money was cheap.
In the pursuit of higher returns, investors were forced to chase riskier assets. And as investors cast a wider net in search of returns, prices rose across multiple assets. The S&P 500 index alone has increased nearly three-fold since the beginning of 2009, with only three years that delivered less than double-digit increases. By the beginning of 2020, the S&P 500 was trading at 13.5x EV/EBITDA, its highest level in over a decade. And then the COVID-19 pandemic began.
As the potential impact of the pandemic began to be understood, public equity markets went into freefall, prompting the Fed to engage in an unprecedented and broad range of actions, including cutting interest rates to zero and providing over $2 trillion of lending support to help stabilize markets, businesses and governments.3 The Fed has also indicated that there would be no interest rate increases until 2023.4 Over a decade of cheap money was given a guaranteed extension likely to last past the three years promised by the Fed.
The S&P 500 responded by trading even higher, despite widespread economic dislocation. Today the S&P 500 is trading at a price-to-earnings ratio of nearly 44x compared with 23x one year ago. Earnings have been negative for the Russell 2000, but the forward P/E for the index was 58x as of late February.5 It is clear that public markets are in bubble territory.
One of the characteristics of today’s equity market bubble is an investor enthusiasm for unprofitable companies that is reminiscent of the dot-com bubble. It has become popular to value companies based on opportunity rather than revenues using a buzzy metric called total addressable market (TAM). TAM seeks to provide a measure of addressable market opportunity for a company or product, but it often views a given market through a winner-takes-all lens, which is rarely the case. Additionally, there are often liberties taken when estimating a market size. So while TAM may offer one piece of the valuation puzzle, relying on it to the exclusion of other, more traditional, metrics carries risk. The Goldman Sachs Non-Profitable Technology Index, which tracks the performance of unprofitable digital economy stocks across industries, is emblematic of this bubble. After trading sideways for two years before hitting a pandemic-induced low in March 2020, the index rose five-fold by mid-January 2021.6
WHY SHOULD INVESTORS BE WARY?
Under normal circumstances, if investors feel an asset class is overvalued, they can simply turn their attention to other, more attractively valued investment ideas. For example, if equities are overpriced, fixed income or real estate may offer more opportunities. But if multiple asset markets are simultaneously overpriced, investors have fewer options, and the benefits of diversification – reduced portfolio risk – are harder to find.
Another issue is performance distortion. In 2020, the S&P 500 was up over 16%, but this market strength is deceptive. As of the beginning of November, five stocks – Facebook, Apple, Amazon, Microsoft, and Alphabet – represented more than 20% of the S&P 500 but were responsible for more than 90% of the gains, suggesting a bubble in the stocks of digital economy companies may be masking the health of the equity markets. These five stocks were up more than 35% at that point, while the other 495 stocks were down 5%. Each of the five set a record high in July. They account for nearly 20% of S&P 500 earnings and more than 80% of earnings growth and the market is paying up for that growth.
The chart below by Morgan Stanley Investment Management (MSIM) shows the bifurcated performance between the 20% of stocks with the highest valuation multiples (what the MSIM Global Multi-Asset team defines as “Anti-Value”) and the 20% with the lowest multiples. Based on this measure, we are witnessing one of the widest valuation gaps ever experienced between the two.
Additionally, the future prospects for many public companies are uncertain. The Fed’s easy monetary policies have fueled borrowing and contributed to the swelling ranks of so-called “zombie companies” – those that aren’t earning enough to cover their interest expenses. According to a recent Bloomberg analysis, more than 20% of Russell 3000 stocks qualify as zombies today after companies in the index added a collective $1 trillion in debt during the pandemic.7 While approximately 60% of zombie companies recover, they tend to experience long-term underperformance resulting from reduced productivity, profitability, and growth.8
AREAS OF OPPORTUNITY WITHIN ALTERNATIVES
Against this backdrop, alternative investments such as private markets and hedge funds may offer investors attractive opportunities for returns and diversification. Combined with strong historical outperformance of vintage-year recessions, this may be an opportune time to shift assets from public equities into private equity.
For investors seeking to diversify their risk exposure away from equities, private markets may offer better return prospects. A private market portfolio can also be allocated to multiple themes, including growth, income, balanced, opportunistic, distressed, and more. In our opinion, private credit is one area of private capital markets that can offer consistent attractive returns with less interest-rate risk and better protections than may be available in public equity markets. In 2020, growth and distressed investments also outperformed public equities but in the coming years, other investment themes will come into favor. A portfolio that invests with a three-to-five-year time frame will provide the flexibility and diversification to allow investors to both participate in the sectors that are performing, as well as be positioned in areas that may currently be out of favor but are still attractive. In private markets, investors get the benefit of partnering with experienced and skilled fund managers whose interests are aligned with investors via personal commitment and an incentive performance fee structure.
The key for investors is to select the right managers, particularly given the significant performance dispersion in the private markets. Experienced, high-quality private equity managers conduct significant due diligence on companies before making an investment, helping to reduce risk, particularly in an uncertain environment. Choosing a manager in the top two quartiles can significantly improve long-term performance.
“Many multi-strategy funds delivered their best returns in over a decade last year, thanks to prudent risk management and the avoidance of concentration, leverage, and illiquidity risk.”
For hedge funds, the benefits of portfolio diversification are driving performance away from the more crowded areas of the market. More recently, we are witnessing yet another bubble, with an incredible rally in several heavily shorted stocks. Companies like AMC Entertainment and GameStop saw their stock prices appreciate by nearly 10x and 20x, respectively, during January. Not 10% and 20%, which would be a great monthly return, but increases that have turned a $100,000 investment into $1 million or $2 million, all in a matter of weeks! Without question, we are living in a world of bubbles, and advisors need to focus on diversifying their clients’ capital into various alternative investment strategies that can improve risk-adjusted results when the inevitable popping occurs.
An environment marked by an abundance of cheap money inflating multiple asset bubbles makes investing an even greater challenge than usual, due to the higher risks involved. Bubbles tend to in ate larger and for longer than anyone can predict. In a time of eye-popping valuations, it is more important than ever that investors pay close attention to the fundamentals and pursue a diversified portfolio. Although the challenges are great, alternative investments offer differentiated returns for investors who are disciplined and want to avoid the emotional investing that too often sways the public markets.
(1) CNNMoney. “Nasdaq Finishes Above 5,000.”
(2) Newsweek. “The Dotcom Bubble Crash Was 20 Years Ago.”
(3) Source: Brookings, “What’s the Fed doing in response to the COVID-19 crisis? What more could it do?” January
(4) Source: MarketWatch, “Dovish Fed sees no interest-rate hikes for years, will keep buying assets,” June 2020.
(5) Source: The Wall Street Journal, as of February 26, 2021.
(6) Source: Financial Times, “This is nuts, where are the profits?” January 2021.
(7) Source: Bloomberg, “Should Corporate Zombies Give You Nightmares?” November 2020.
(8) Bank for International Settlements, “Corporate zombies: Anatomy and life cycle,” September 2020.
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