Why 2022 Could Be The Dot-Com Bubble All Over Again

Summary

• Speculative growth stocks have become unreasonably expensive.
• Persistent inflation will trigger higher interest rates, causing high growth to crash.
• Capital will flow out of "dumb money" into fixed income and cash-flow generating stocks.
• High growth companies with no earnings will be hit the hardest, and could see a 30% drawdown over the next 18 months.
• The best way to protect your portfolio is to shift money out of speculative stocks and into high-quality stocks.

DNY59/E+ via Getty Images

Thesis

I'm often skeptical of market alarmists who make outlandish predictions about massive market crashes. Over the last decade, investors have been wise to tune out these perennially wrong permabears. However, over the past few months, I have become increasingly convinced that specific pockets in the equity markets could be on the verge of a full-blown melt-down. Specifically, I worry that high-growth equities, artificially elevated by low interest rates, will see a significant correction over the next 12-18 months as the Federal Reserve combats persistent inflation.

I don't write this to try and scare investors, but rather as a call to protect your portfolio from this meaningfully probable event. The best way for investors to protect their portfolio is to reduce their exposure to overvalued pockets of the market like EVs, gene-editing, crypto, space travel, and profitless software. Instead, investors should shift money into high-quality, cash-flow-generating stocks.

Inflation

A key component to my tech bubble 2.0 thesis is that the Federal Reserve is underestimating the degree to which inflation in the U.S. has gotten out of control. In October, U.S. consumer prices rose 6.2%, the highest inflation increase in over three decades. The top contributors to overall CPI were energy (up 59% YoY) and vehicle rentals (up 39% YoY).

Source: The New York Times

The Fed's story about inflation has shifted over the past couple months. At first the claim was that inflation was transitory and price increases would begin to slow in the second half of 2021. However, as prices have continued to climb, the Fed has been forced to shift the narrative, blaming persistent price increases on temporary supply-chain issues. I have two problems with this explanation. Firstly, how do we know that the supply chain problems will resolve anytime soon? The evidence seems to point in the opposite direction as shipments issues on the West Coast could turn 2021's supply chain crisis into 2022's supply crisis. Secondly, the Fed ignores possible demand-side inflation as the U.S. reopens with COVID-19 infections falling due to increased vaccination rates and the approval of highly efficacious medications from Pfizer and Merck. A supply/demand inflation combo could send inflation spiring into the high single digits in the first half of 2022.

History has shown that inflation is good for equities, until the Fed has no choice to take it seriously and act. I am confident that the Federal Reserve will have no choice but to significantly expedite its tapering process and begin raising rates sooner than currently projected. This brings us to the second piece of my 2022 melt-down thesis: interest rates and valuations.

Interest Rates & Valuations

As Warren Buffett puts it, "interest rates are to the value of assets what gravity is to matter." It is almost impossible for me to express in writing the impact of interest rates on markets and economies. Nearly every asset bubble of the last fifty years can be in some way explained by dovish monetary policy. Low rates explain everything from stock market all-time highs to silly internet currencies. Low-interest rates make it possible for your half-drunk college roommate to outperform some of the smartest money managers in the world. When interest rates get low enough, there is little limit to how high asset values can go. When money market accounts yield 20 basis points, putting your Bar Mitzvah money into Dogecoin doesn't seem like such a bad idea.

However, when rates begin to normalize again, there can be significant financial pain. Another timeless Buffett quote perfectly describes this market phenomenon: "Only when the tide goes out do you discover who's been swimming naked." The ones who have been swimming naked are those who have spent the last few years heavily invested in high-risk, high-growth stocks. The further in the future a company is projected to produce profits, the more sensitive they are to rising interest rates.

Source: MacroTrends

Let's use a simple example to display this fundamental valuation truth. Take two companies, Company A and Company B. Company A is a well-established industrial conglomerate. Company A expects to produce $1 billion in annual cash flows over the next five years before going out of business in year 6. Company B is a fast-growing software firm that expects to produce no cash flows over the next five years and expects $1.5 billion in annual cash flows in years 6-10 before going out of business in year 11.

With a Discount rate of 7%: Company A is worth $4.1 billion and Company B is worth $4.4 billion.

Source: Created by Author in Microsoft Excel

With a Discount rate of 10%: Company A is worth $3.8 billion and Company B is worth $3.5 billion.

Source: Created by Author in Microsoft Excel

With a modest rise in rates, Company B went from being worth more than Company A to being worth less than Company A. When the discount rate rose from 7% to 10%, Company A's value only fell 7% while Company B lost over 20% of its value. This is the danger of investing in speculative growth stocks when rates are low. Now is the time to shift your money out of Company B types and into Company A types.

Greed & Fear

If you've ever taken an undergraduate-level finance course, you have probably been introduced to the "Efficient Market Hypothesis," the idea that the value of an asset is equal to its market price because the market reflects all available information. There is one crucial problem with this theory. Human beings are not robots. Humans are emotional and irrational animals who time and again succumb to two powerful emotions: fear and greed.

Greed is the result of low-interest rates. The cycle goes something like this: low rates makes borrowing cheap and saving unattractive, which causes equity prices to rise. No one wants to see their less intelligent neighbor getting rich while they miss out, so new investors join the market and buy more equities, and so on.

Fear is the result of rising interest rates. When prices get too high due to greed, the Fed has to raise rates to squash runaway inflation. When the Fed raises rates, high-risk assets decline significantly. Since everyone was greedy and overexposed to high-risk stocks (Company B's), investors sell their high-risk stocks out of fear they will keep falling. This is how market crashes start.

Source: FXStreet

I believe we are at an inflection point. Over the next 18 months, greed will transition to fear for high valuation equities. The last decade of markets has been defined by what I call the "This Time Is Different (TTID) Effect." Since 2011, market commentators have predicted dozens of market crashes that have failed to materialize. With each new dip and an all-time high, investors' confidence grows, and they extend themselves further and further on the risk curve. Nicholas Taleb, the author of the Black Swan, calls this "The Turkey Problem." The example he gives is a Thanksgiving day turkey that is well-fed every day for 1,000. Each new day, the Turkey's belief in its well-being rises, until the 1001st day when it is slaughtered by the butcher. If you want to be a good investor, don't be a turkey.

Source: Wealest.com

How To Protect Your Portfolio

Now that I've gone into detail about my three-part market prediction, I will discuss how to protect yourself from an interest rate-induced correction. The best way to optimize your portfolio is to shift your money into high-quality stocks. High-quality companies have strong cash flows in the present and are less impacted by interest rate changes. Some reasonably valued, high-quality stocks I like are Verizon (VZ), Lockheed Martin (LMT), Alphabet (GOOG) (GOOGL), and Intel (INTC).

Another key to surviving a market revaluation is to increase your cash position. If you are a more cautious investor, raising rates could allow you to invest in fixed income. If you are a higher-risk investor, excessive fear could cause high-growth stocks to fall to attractive levels, which could be a great buying opportunity. The most important thing is not to be too late when making a portfolio shift. As recent market events have shown us, market cycles are happening quicker and quicker these days, so you don't want to hold onto your speculative stocks too long.

Why I Could Be Wrong

There are two main reasons why my market prediction could be wrong: inflation cools or a technology boom offsets raising rates.

The first reason why my market bubble thesis could be wrong is if inflation slows down. Supply chain issues may be resolved soon, and a new oil supply could reduce energy prices over the coming months. Additionally, higher COVID-19 infection rates could stop the economy from overheating and keep CPI from spiraling out of control. If this is the case, my entire hypothesis breaks down, and the Fed would no longer have to quickly taper and raise rates. If the Fed doesn't significantly raise rates, then the bull market continues.

The second risk to my market prediction is that the U.S. experiences a technology boom that offsets any rise in interest rates. For the past decade, analysts have rated cloud software companies like ServiceNow (NOW) and Salesforce (CRM) overvalued. However, they were wrong for one reason: these companies grew faster than almost any analyst projected. Even if an interest hike caused multiples to contract, if fast-growing companies outperform projections, they could still see their stock prices grow even in a higher interest rate environment.

Conclusion

When it comes to predictions, the most important thing to remember is that the probabilities are out-known, but the outcomes are not. I cannot quantify the odds of a 1999/2000 style blow-up next year. My only certainty is that if it does occur, there will be a lot of financial pain. Runaway inflation, rising rates, and a crash in speculative assets is real threat to markets. The best way to protect yourself is to diversify into high-quality, cashflow producing stocks that can weather a market downturn.

Disclosure: I/we have a beneficial long position in the shares of GOOGL, LMT, INTC either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.