Valuations Bubble Will Likely Continue

Summary

• During the correction, we have had some rotation from growth into value stocks; however, we believe that this rotation will prove fleeting, as economic data continue to stall.
• This week's financial data have shown that economic recovery has been slowing, giving a clear signal that the Fed's liquidity boom and the fiscal stimulus have disappeared.
• Fed continues to provide support after it announced on Wednesday that interest rates will remain unchanged throughout the next three years.
• This week, we saw an increase in market speculation: the Leveraged Nasdaq ETF (TQQQ) had record inflows, and the snowflake IPO that soared 112%, making the company five times more valuable than it was worth months ago as a private company.
• We believe that markets will rise in the short term, fueling the valuation bubble; we have to remember that there's nearly 5 trillion sitting in money market funds waiting to buy this pullback.

For the third consecutive week, the S&P 500 and the Nasdaq closed in the red, as sharp losses in the tech sector continued. As shown in Figure 1, the S&P 500 tumbled 1.1% to 3,319, the NASDAQ 100 fell 1.3% to 10,936, and the Dow Jones dropped 0.9% to 27,657. The energy sector gained the most, as it climbed 3%, followed by Industrials and basic materials (Figure 2). The three key sectors: tech, consumer discretionary, and communication services, were among the worst performers for the week, dragging the whole market down (Figure 2).

Figure 1: Major Indices week ended in September 18 performance

Source: KOYFIN

Figure 2: U.S Sectors week ended in September 18 perfomance

Source: KOYFIN

The decline in the equity markets continues to be driven by the decrease in mega-cap tech stock, as investors continue to fear over bubble valuations in the market. As a result, according to data compiled by Goldman Sachs Group Inc's prime brokerage unit, professionals managers have been decreasing their allocation to the tech sector in favor of more cyclical stocks trading cheaply relative to earnings or book value. This rotation into value stocks can be seen in Figure 3, as it shows value stocks poised for the best month since 2008 versus growth shares.

Figure 3: Value vs Growth Index

Source: Bloomberg News

However, we believe that value will continue to underperform despite the current revival. As shown in Figure 4, we have seen that value stocks have attempted three times to reverse their underperformance in the past months, but they have proved fleeting. We have to bear in mind that we need a more robust economy that will lift the value sector's business cycle to outperform growth.

Figure 4: Value vs growth stocks reversal in the last months

Source: Bloomberg News

Economic Data

As we mentioned, this rotation to value stocks will not happen until we have a more robust economy, which, according to this week's economic data, this rotation will take some time. This week's essential economic data are: the weekly unemployment claims, retail sales, industrial production, and some high-frequency data.

The seasonally adjusted initial jobless unemployment insurance claims declined to 860,000 in the week ending September from 893,00 in the previous week; however, these figures came below market expectations of 850,000. Retail sales decelerated in August after the figures were softer than expected at +0.6% vs. 1% est. & +0.9% in the prior month. The decline means that the consumer pulled back on visits to retail outlets last month, signaling a slow recovery. On the other hand, industrial production appears to be stalling as it reported a below expectation (1%) increase 0.4% during August following a 3.5% increase in July. As shown in Figure 6, retail sales have been stalling but are still above their pre-pandemic levels. However, the problem is with industrial production as it remains nowhere near its pre-pandemic levels.

Figure 6: Retail Sales and U.S industrial Production

Source: Bloomberg News

On the high-frequency data, we continue to see some decline. Apple mobility data continues to stall; the hotel occupancy rate continues to decline along with hotel occupancy rate; however, the only improvement is Open table reservations but still is well below early September levels (Figure 7)

Figure 7: High-Frequency Data

Source: Pantheon Macroeconomics

So, this week's economic data have shown that the economic recovery has been stalling, giving a clear signal that the liquidity boom fueled by the Fed and the fiscal stimulus has disappeared. On the fiscal side, it's clear that fiscal stimulus in Q2 has been a significant driver in the economic recovery. According to the BEA, the stimulus boosted personal income by 3.2% annualized. However, the stimulus ran out in late July, and since then, it's expiration has been slowing the economic recovery. Furthermore, Congress continues to fail to come to an agreement as both parties continue to fight over the size of the stimulus. In our last market assessment, we talked about the approval of the second fiscal stimulus before the election. However, our expectations have changed: we don't believe that we will have a second round of fiscal stimulus before the election, therefore, we expect economic data to continue to stall until we have the stimulus.

On the monetary side, the Fed has done a great job boosting a liquidity boom. An analysis by BIS.org concludes that the Federal Reserve's actions during the COVID-19 crisis have accounted for half of the S&P 500 (Figure 8). However, due to their efforts, interest rates and bond market volatility have been at record lows, and market speculation continues to rise. The options market reflects the belief: as single stocks options raised to record volumes at the start of September and as options contracts with maturity less than two weeks out comprise 75% of trades in July, according to data compiled by Goldman Sachs Group Inc,

Figure 8: Stock indices components performance

Source: Bis Calculation/ BIS.org

Bond market volatility at record lows after Fed announced that interest rates will remain unchanged throughout the next three years

On Wednesday, the Fed announced at the FOMC meeting that interest rates would remain near zero for at least three years, vowing delay on the tightening until the U.S gets back to maximum employment and 2%. As shown in Figure 9, the Fed is projecting core PCE inflation of 1.5% this year and a 2% until 2023, in the meanwhile, interest rates will remain unchanged near the zero bound.

Figure 9: Fed projection for Core PCE Inflation and Interest Rates

Source: Twitter

As a result, expected volatility for the next month hit a historic low this week (Figure 10). The treasury market is unmoved; treasury yields continue to fall to record lows. The 10-year rate has stayed in a range of barely ten basis points all month meaning that investors don't believe that inflation will pick up anytime soon.

Figure 10: ICE BofA MOVE Index

Source: Bloomberg News

Valuations bubble will likely continue

We have had a correction in equity markets driven mostly by the mega-cap tech stocks in the last two weeks. However, speculations continue to increase: During the correction, we saw a crowd of traders piling up into the triple leveraged ETF that tracks the Nasdaq (TQQQ); the ETF attracted more than 1.5 billion during the correction, it's the best streak of inflows on record (Figure 11).

Figure 11: TQQQ Us Equity Fund Flow

Source: Bloomberg News

Then we saw the snowflake IPO: Snowflake soared 112% on its first day of trading, the best first-day pop for a billion-dollar IPO since 2000. As a result, the company is now five times more valuable than what it was worth as a private company, which obviously flashes a warning signal of the speculation we are having in the market despite the current correction.

Conclusion

The market is currently at correction driven mostly by the decline in mega-cap tech, as investors fear bubble valuations. During the correction, we have had some rotation from growth into value stocks; however, we believe that this rotation will prove fleeting, as economic data continue to stall. This week's financial data have shown that economic recovery has been slowing, giving a clear signal that the Fed's liquidity boom and the fiscal stimulus have disappeared. Congress has failed to provide support; Thus, we believe that there will be no stimulus before the election. Fed continues to provide support after it announced on Wednesday that interest rates will remain unchanged throughout the next three years. On the other hand, this week, we saw an increase in market speculation: the Leveraged Nasdaq ETF (TQQQ) had record inflows, and the snowflake IPO that soared 112%, making the company five times more valuable than it was worth months ago as a private company. Markets are remaining overbought long-term despite the recent pullback. We believe that markets will rise in the short term, fueling the valuation bubble; we have to remember that there's nearly 5 trillion sitting in money market funds waiting to buy this pullback.