- High-beta social media, biotech and cloud stocks have experienced a blood bath.
- Yet large caps are within striking distance of all-time highs.
- A reversal of the Fed's zero interest rate policy should continue to drive capital out of speculative stocks.
For what seemed like forever we had "Mr. Miyagi" markets. Instead of "wax on, wax off" it was "risk on, risk off" with everything slamming in one direction or the other.
Now the amount of divergence is eye-opening. High-beta, social media (such as Facebook (NASDAQ:FB) LinkedIn (NYSE:LNKD) and Twitter (NYSE:TWTR)), biotech (NASDAQ:IBB) and cloud names such as Amazon (NASDAQ:AMZN) and salesforce.com (NYSE:CRM) have generally experienced a bloodbath. Small caps (NYSEARCA:IWM) are in a topped-out, broken-down, ready-to-capitulate position from both a price action and sentiment perspective. Yet large caps - e.g. Dow (NYSEARCA:DIA) and S&P (NYSEARCA:SPY) are within touching distance of new all-time highs.
Why the major divergence? Why are small caps getting hammered while big caps hold up?
One reason is concentrated money manager exposure, as outlined in "Tiger Soup." But a broader reason has to do with macro shifts in the market landscape.
High-beta tech stocks are a claim on future cash flows far, far down the road, with current payouts of zero. As such, they act like volatile zero coupon bonds with high sensitivity to interest rates (or a forecasted change in interest rates). This was not our original observation (credit goes to Calamos Investments) but it is a very apt comparison.
In the ZIRP (zero interest rate policy) Fed environment, you could create a discount rate of practically infinity (or close to it) for future cash flow streams; because the benchmark of returns you were comparing it to (the present risk-free interest rate) was zero or close to it. Such comparisons were then juiced phenomenally by a general sense of "zero rates as far as the eye can see." This central-bank-created environment had an extreme impact on high-beta valuations.
Or put another way, when money is basically free (for pedigreed institutions with great credit that is), broad economic growth prospects are terrible and it's hard to find returns, the Silicon Valley moonshots of the world offer a chance at true exponential growth and crazy discounted cash flow justifications. So everybody piled in, to the point where public mutual funds were even doing pre-IPO valuation deals. This was as good a sign as any that things had gotten nuts:
That mutual fund in your retirement plan may be moonlighting as a venture capitalist.
BlackRock Inc., T. Rowe Price Group Inc. and Fidelity Investments are among the mutual-fund firms pushing into Silicon Valley at a record pace, snapping up stakes in high-profile startup companies including Airbnb Inc., Dropbox Inc. and Pinterest Inc.
The investments could pay off big if the companies go public or are sold, helping boost fund returns. But, as the recent turmoil in the market for technology stocks and initial public offerings has shown, such deals also carry major risks not typically associated with mutual funds…
"These are unproven companies that could very well fail," says Todd Rosenbluth, director of mutual fund research at S&P Capital IQ. If things go badly for a startup, "there may not be an exit strategy" for the fund firm.
What was that Buffett line about "innovators, imitators and idiots?" Hmm…
But anyway, that was then, this is now. The macro environment no longer favors silly season moonshots benchmarked off a forever-zero rate environment bereft of real investment alternatives.
Instead, a steadily improving (albeit slowly and weather-interrupted) U.S. economic picture, coupled with increasing prospects for rate hikes in a twelve to eighteen-month window, means the levitating pixie dust has worn off. Not only will future cash flow prospects (or lack thereof) have to be more realistically discounted when interest rates actually rise as the U.S. economy heals, all of a sudden there are more attractive value propositions in real "stuff " stocks - companies that actually make things and sell them to consumers, and have relatively low valuations and attractive dividend yields.
Then on top of all the above, throw in late-cycle factors and a general "flight to quality" mindset among portfolio managers who know the hour is getting late and safety is becoming more paramount, e.g. return "OF" capital eclipsing return "ON" capital as a prime driver. In result you get a rotation not just into large cap quality, but "best of breed" type quality, the names with the best "boring" credentials like solid cash flow, attractive valuation and yields, and so on.
To use a highway metaphor, the little red sports car of high-beta no-cash-flow has crashed and burned. The new hotness is a Lincoln Continental that drives like a boat but won't leave you in a steaming wreck by the side of the road when the oil slick of anticipated rising rates mixes with the light spring rains of economic pick-up.