Weakness in markets during September, particularly technology-related companies both onshore and off, should tell us something is changing at the economy-wide level.
The status quo of this recession is unique. The post-March rally was based on the fortunes of a telecommuting or furloughed caricature of an employee receiving large cheques from the government, mortgages stayed, with nothing to spend money on but streaming devices or day trading on Robinhood. This stereotype is breaking down. But how, or why?
The current equity market dominance of the pandemic-proof FANMAG companies requires a continuation of free money. Banks are rolling back credit card lines and automatic mortgage, and rent moratoriums are expiring. Face-to-face businesses, large employers of the more economically vulnerable, are now priced for bankruptcy. Will the governments of the world stand back and watch the recession take its natural course, or will our elected officials do what gets them elected and spend more money?
One of the strongest signals for future market performance is momentum, the historical price performance of any asset. It is pervasive, robust, and global in nature. Within finance, we have never really found the underlying cause of momentum, until recently. We always thought momentum was about slow news, the phenomena that market insiders learn information about a company, and it takes some time for the public to discover the changing fortunes of a company. The insider’s transactions drive performance in a particular direction, soon followed by the wider investing public.
The slow news explanation now seems unlikely. Within academic circles, we now understand that momentum is a macro-economic phenomenon. Macro-economic cycles tend to perpetuate. It is in everyone’s interest for growth periods to continue. Companies that do well in a particular economic state tend to continue to do well in that economic state.
But, momentum has an Achilles heel. Betting on the continuation of the current economic state, whether perpetuating a growth cycle or a recession, will give us small and somewhat constant gains. This is a “picking up coins” strategy. Unfortunately, economic fortunes change. And when they change, they can change fast and violently. These disruptions are known as momentum crashes. We also call them the steamroller. Momentum investing can be likened to “picking up coins in front of a steamroller.” A lot of small gains, and then when we trip and the steamroller gets us, a large loss.
This is a recession like no other. Large technology companies have been some of the biggest beneficiaries. Large government income support has been pushing on the consumer like a rope. We are locked up in our homes, telecommuting, looking for entertainment, either to be streamed or hoped to be turned into quick gains by buying the winners on the free-to-trade Robinhood. As a result, FANMAG companies are growing without bounds.
In a recession, we expect the cheap and weak companies to do poorly, and this year they have. Through the cycle, we normally see the ratio of the cheapest to most expensive companies trading at about 41 cents to the dollar. The ratio as of 30 June 2020 is 14 cents to the dollar in the US and 19 cents to the dollar in Australia. Saying it another way, the equity market is pricing in a 50 per cent to 60 per cent bankruptcy risk for vulnerable companies in both markets.
The poor showing of tech companies during September tells us that the economic status quo may be changing. We are not seeing a recovery, an unleashing of spending on the old economy of socially integrated expenditure, group entertainment, restaurants, or pubs. The at-risk companies have not seen their prospects improve.
So, what are we seeing? What we are seeing is a risk to the bubble prices of the lofty companies that have done so well this year, despite everything thrown at the global economy.
Companies with the largest historic price performance over the prior year are usually priced at historic ratio to those with the worst annual performance of $1.62 to the dollar. They trade at a premium. As of 30 June 2020, the premium is $5.05 to the dollar in the US, and $3.27 to the dollar in Australia. We last saw ratios like this at the last days of the tech bubble in early 2000, and that required the mass commercialisation of the internet. This time it took a global pandemic to extend further the meteoritic dominance of tech and entertainment giants.
So, what is turning the tide on the lofty valuations of these few tech giants? It is the reality of the recession coming home to roost. It is the paring back of cheques, of mortgage and rent moratoriums. Will September’s momentum reversal be just a head fake or a tide? That is up to the government. Will they continue to trounce contract law and support the consumer? Will they continue to expand government debt levels despite concern of future inflation? Or will they push the global economy into an income and bankruptcy-led recession?
They are, and will continue to be, our elected officials. I know what I am betting on. Spenders gotta spend!
Mike Aked is director of research for Australia with Research Affiliates
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