JPM with the note. Assuredly, stock markets are not the economy but they are a discounting mechanism and what everybody may be missing is that they may, in fact, be pricing for the six shocks rocking Europe (war and energy), China (OMICRON and property), and in the US the Fed. There’s a lot more going on here than just the last.
You might want to sit down for this…
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What’s happening? Interest rates are rising, the Fed is tightening, and the world is grappling with inflation. These machinations follow a global pandemic where China is still experiencing mass lockdowns, while the conflict between Russia and Ukraine puts further pressure on supply chains and inflation. The market continues to teeter between complete apathy and bewilderment. We have been in a low growth, low interest rate environment for well over a decade, an environment that was easy for growth companies to flourish. The world is changing quickly, and enormous intellectual flexibility is required when navigating the current market dynamic. The past few years have proven good companies and stories dont necessarily make good stocks.
The market remains about time, not price. Investors need an all-clear on the macro landscape; until then, the hurdle rate for new risk will remain high, and many will remain in self-preservation mode. The one positive right now is that everyone seems to be universally negative. Bulls are licking their wounds, and Bears aren’t overly optimistic about their prospects either. Much of what we have seen on our desk has been risk management and rightsizing more than anything else. It’s also a midterm election year, which historically proves challenging for Q2/Q3 performance.
Below I have included (more than) a few thoughts on the broader market narrative and sentiment, positioning and performance, private markets, the impact of crossover investors, the parallels to the dot-com bubble, the deprioritization of growth, the funding and M&A landscape, the impact of the retail investor and the ever changing streaming business.
Where do we stand?
Just because it makes sense doesn’t mean it feels good. The markets current recalibration of valuations makes sense in the scope of the gains seen since 2018 and 2020. Despite its current 26% drawdown, the NDX is still up 90% from the start of 2018, and +35% from the beginning of 2020. The SPXs 17% drawdown from the highs its still +49.7% & +23.5% in those same periods
Valuation. The market has broken below its 4200-4600 trading range, leaving investors to ask where and what is next. The crosscurrents and complexity in the market have spurred vigorous debate around the price and earnings inputs feeding into the P/E multiple for the market. Its worth noting that the last time rates were >3%, the SPX was <3,000. Using $240 in EPS for 2023, 14x equates to 3,360, 16x is 3,840 & 18x is 4,320. We probably reset into the 3,800-4,300 as the interplay between valuations, rates, macroeconomic and geopolitical factors all become socialized by the market.
- Growth Valuations: The pure SaaS space has now de-rated to ~6.2x forward EV/NTM Sales (vs. 11.7x as of 12/31, 16x+ in early 2021 & 6.2x since 2006); this compares to a 12.3x average multiple over past three years. Software more broadly is trading ~5.7x NTM EV/Sales, vs. ~11.1x on 12/31/21 & 4.8x since 2000. Moving away from revenue multiples, Software is trading 24.9x EV/NTM FCFF (vs Long Term Average 19.8x) while SaaS is trading 26.4x EV/NTM FCFF (vs. Long Term Average 26.6x).
When rates are low, investors are willing to eschew profitability for revenue growth, but those days have come to an abrupt halt. The mass adoption of probabilistic investing is only part of what inflated valuations. Many investors began buying names in both public and private markets alike solely on the merits of being in industries with large TAMs, even without valuation or business model justifications; this became a virtuous cycle for valuations. Growth companies all reached such nosebleed-level altitudes during Covid that they ran out of oxygen simultaneously. Such activity will likely take a sizable pause. Companies are now trying to demonstrate financial discipline and extend their runway; those with sizable cash burns and funding needs will probably find this to be a challenging period.
Between the dot-com bubble, global financial crisis, 2011, 2016, 2018 & Covid, The Fed ultimately buttressed the markets with policy changes and rate cuts, while strengthening the market’s confidence of a ‘Fed put’ for when things go awry. The Fed’s mandate is for price stability and maximum employment. While the Fed has proven to be mindful of stock drawdowns, I think we’d all agree they’re likely looking at the current inflation dynamic with a more critical eye than SaaS stocks related to price stability. The Fed needs to overtighten so they can ease at a later date. The Fed was wrong about inflation being transitory, and now it will take all ‘necessary steps’ to address it; the safety net is a long way away. The Fed still believes in transitory, albeit a different timeline. Bostic said we can do 2-3x more hikes and then pause & assess, which means zero, 25bps, or 50bps in September. The Fed thinks a more prolonged expansion is possible, which also serves their social agenda.
Supply Strains. We have learned that the global supply chain is inextricably linked, and akin to what we have all learned about sleep over the years, excess supply chain capacity cant be banked and saved for later. The issue is these will take time to work through, and there’s little the Federal Reserve can do about it. While countries might become more insular and view supply chains as increasingly crucial to national security, mass de-globalization is not a sustainable trend. Part of the supply chain might get repatriated, thus leading to more expensive means of production. However, the positive upshot might be more redundancies and capacity in the global supply chain.
Inflation. For the first time in my career, we have seen real inflation. Inflation always seemed like this boogeyman, but now that we have seen it, it will linger for a while. Its very hard to put that genie back in the bottle.
Low Visibility. Companies have not been accurate in forecasting their businesses over the past few quarters, especially those that benefitted from COVID (e.g. NFLX). Investors have subsequently lost confidence at a time when company guidance has likely been building in a larger margin of safety.
Earnings for the quarter were mostly ok, though the outlooks were disappointing. The tenor was especially concerning from Amazon (excess capacity post COVID), Akamai (softer internet traffic), Shopify and Wayfair’s growth underwhelmed, all in a construct where fiscal tightening constricts multiples.
The next big thing isn’t so clear. Emerging from the GFC, many of us got our hands on the iPhone for the first time, and the future of mobile commerce and the emerging importance of the cloud became apparent to the early adopters. The next big thing is a bit nebulous from here, and perhaps it doesnt reside in traditional TMT but in alternative energy/nuclear, immunotherapies, autonomous software testing or space (for the purpose of this exercise, I’m purposely omitting Web3 and the metaverse).
Everything got pulled forward. The quote by Vladimir Lenin ‘There are decades where nothing happens, and there are weeks where decades happen,’ rings very accurate. The repricing of risk and valuations tends to be swift and indiscriminate, but we have often seen it. This time around, it feels like we might make a bee-line to put in a floor; and we might stay there for a while.
- Covid was, in fact, a negative for the Covid beneficiaries. The demand pull-forward during Covid for names like DOCU, PTON, DASH, TWLO, ROKU, NFLX, SHOP, CHWY, etc. was palpable. Remarkably, all of those aforementioned are below pre-Covid levels.
The stock market (especially the NASDAQ) is NOT the economy. While fiscal conditions could lead to a recession down the line, just because SaaS companies are bleeding a lot of market cap doesnt mean theres a loss (or even a stress) in economic activity.
Are we there yet? I just got back from a family trip to London, and I came across this quote at the Churchill War Rooms (which I highly recommend) that explains my thinking about where we are in the selloff right now. ‘Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.’
- We are starting to see some portfolio movement. While flows havent quite been capitulatory yet, we have begun to see some of the more prominent growth players on the long-only and hedge fund side start to (finally) unwind some of these positions.
Is Stagnation the most likely outcome? Perhaps for stock prices, especially in growth, but the overall economy is still buttressed by strong consumer balance sheets and more money raised by corporates at low rates around and after the pandemic.
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Charts, Fancy Pictures & Stuff …
Market Multiples: Concern around earnings and debate around the multiple
Normalized Returns YTD: Unprofitable Software -49%, Internet -45%, NDX -26%, SPX – 17%, 10 Year Yields -181%, VIX +206%.
Covid Beneficiaries = Covid losers. The Covid pull-forward proved to be a negative for those that benefitted the most.
US Financial Conditions vs. 30-year Fixed Rate Mortgage
SPX Drawdown dropped as low as -20%(yes, we were in a bear market for a few seconds today) vs ~20% in 2018
The NDX drawdown is currently 30%, which is more than the 28% Covid drawdown and ahead of the 23% drawdown seen in 2018.
Zooming Out: The NDX drawdown looks a lot more precarious vs. the ~83% drawdown seen post the dot-com bubble.
Volatility Anyone? Average 1-day % change in the NDX. NDX Volatility is currently 37.5% vs. the VIX @ 33. Investors will want to see this fall closer to 20 to facilitate a sustained rally.
NDX | Percentage with new 52-week lows. ~31% of the NDX are at their 52-week lows; this hit ~37% during the 2018 sell-off & ~53% in 2001.