Imagine a child’s favorite food is birthday cake. He loves it so much that his fondest wish is to eat birthday cake for every single meal.
Then, in some Twilight Zone version of reality, his wish is granted. He gets nothing but birthday cake, for every single meal. Morning, noon, and night.
At first this would be great. The kid would be ecstatic. Eventually though, he would get sick of it. After a long-enough period, he would be sick of birthday cake. The sight of it would turn his stomach. A food he once loved would give him pure indigestion.
The Federal Reserve promised to hold interest rates near zero until 2023 this week. This was the equivalent of more birthday cake for investors — lots and lots of birthday cake, as far as the eye can see.
Investors weren’t thrilled. Technology stocks stumbled this week, even in the aftermath of the Fed’s endless birthday cake announcement.
Not even the joyful ruckus of the Snowflake initial public offering — the largest software IPO in history, by far — kept the Nasdaq Composite from struggling to hold its 50-day moving average.
At a certain point, enough is enough.
Part of the problem is that even the cash-rich juggernauts — the FANG names (Facebook, Amazon, Apple, Netflix, Google/Alphabet) making money hand over fist — feel the pull of gravity at their outer reaches of valuation.
The higher the multiple goes, the greater the force that gravity’s pull exerts. This makes the climb harder and harder as price extremes are reached.
It’s kind of funny, actually: When you have a stock whose valuation is completely nuts, like Tesla (TSLA), the price can go anywhere, because the valuation means nothing. A multiple on crazy is just more crazy.
But this mentality works best when there aren’t any cash flows — when the company is all blue sky and hype, allowing superfan investors to dream up any future story they want.
When a company has a bulletproof stream of cash flows, in the manner of, say, Apple (AAPL) or Facebook (FB), investors are paying a premium for those cash flows. This creates a tether to the real world. Investors can find ways to justify ever higher multiples, but eventually the logic is maxed out.
Imagine a company guaranteed billions in profit, every single quarter, for years or even decades into the future. The stock price of this company — by way of the multiple — will “price in” future earnings.
If the stock has priced in, say, the next 20 years of stellar earnings, it will cease to matter how bulletproof the cash flows are. It will be hard for the stock to go much higher.
When interest rates stay near the zero-bound for long enough, and valuation multiples are bid high enough, the likelihood of further stock upside goes down. The multiple simply maxes itself out.
It’s possible we are moving closer to that point.
Take Apple, for example, a company whose wild price appreciation, and multiple expansion, was more about limited choices in a zero-rate world than any positive shift in Apple’s business prospects.
On Sept. 1, at the peak of the post-split frenzy, AAPL shares traded at a forward-price-to-sales multiple of 7.7X.
Never before in all of history had such an extreme level been reached. Dating back to 2007, when the iPhone launched, Apple’s typical price-to-sales range was somewhere between 2X and 4X.
Given that rule of thumb, in 2020 we have seen a near-doubling of Apple’s share price — a more than 90% share price rise — on nothing at all but multiple expansion.
The cash flows remain impressive. Investors simply decided to bid the multiple on those cash flows to incredible new heights, thanks to the multi-year outlook for a zero-interest-rate world.
As of this writing Apple’s forward-price-to-sales multiple is 6.6X. This means that Apple could go on being Apple, booking huge profits every quarter, and a mere mean reversion to the top of its old price-to-sales range — not the bottom, mind you, but the top — could mean a roughly 40% share-price drop.
If it merely fell to the middle of the old range, in terms of this standard valuation measure, Apple’s share price could fall by more than half. And this could come in the absence of any bad news on the China front or the iPhone sales front.
Is the point here to make a doom-and-gloom forecast for Apple? No, not at all.
The point is that the Federal Reserve has fed investors so much birthday cake (in the form of a zero-rate environment) that investors have bid up cash-rich tech stocks to multiples where prices could fall sharply, even dramatically, without requiring any slowdown in the business of these companies, or any kind of dent in the profit outlook.
That, in turn, means high-profile technology stocks could trade like currencies or commodities in the months and years to come, responding more to changes in the macro environment than to ups or downs in the business model (assuming business continues to go well).
An investor loaded up on Apple shares, if they are honest and macro-aware, would have to make a plausible argument for why Apple’s valuation multiple is now so wildly inflated, in a time where smartphone markets are mature, relative to all the years in which Apple has made iPhones.
And that is fine. The investor could make that argument, to be sure.
But the problem is that, if Apple is now trading at hyper-inflated multiples on the basis of macro factors, then shifts to the macro — changes to the economic growth outlook, changes to inflation expectations, things like that — could start swinging Apple’s share price around far more than the fundamentals of, you know, actually selling iPhones.
Then, too, Apple is just a prime example. This goes for the whole FANG group.
To the extent these stocks are appreciated for their bulletproof cash flow streams, and bid to stratospheric multiples on the basis of birthday cake, their super-inflated share prices have the potential to now go down, not just up, in multi-month trends that could last for months at a time, or even whole quarters at a time.
This means that traders who understand macro-influenced trading instruments — like, say, commodities and currencies — could have a significant edge in handling tech stocks moving forward, while investors who are still trying to invest based on fundamentals, for example looking at the outlook for the new MacBook Pro, will be out of the loop.
This is also part of a broader theme. As the whole world goes more “macro” — thanks in part to the distortions of interest rates at the zero bound for years, and debt levels at historic extremes not seen since World War II — the trading component of trading and investing will become more and more important.
That, in turn, means to expect more trends that run for months in both directions — down as well as up — with greater ability to respond to price movements and fundamentals together, rather than investment assumptions alone.