A high-profile hedge fund manager is warning that an “enormous” bubble in technology stocks has popped. He believes the top was registered on Sept. 2, 2020, that investor sentiment has shifted from “greed” to “complacency,” and that bear-market pain for technology stocks is ahead.
Is he right? Possibly, yes. The reasons he cites for calling a tech-stocks top will be familiar to TradeSmith Daily readers, as we have touched on some of them over the past few months.
Among those reasons are the fact that Silicon Valley engineered a retail trading mania (as we noted on July 13); the various reasons stocks could retest the March lows (as noted on Sept. 14); and the reasons why, in leveraged conditions like the ones we now see, you don’t need fear to see a big market decline (as noted on Sept. 17).
It is also possible this hedge fund manager is wrong, however, and the top for tech stocks is not yet in. He previously called for a tech-stocks top in 2016, and was certainly wrong then (more on that shortly).
Whether wrong or right, a top call is a statement about the future more so than the past, because a top call in effect says prices will not go higher for years to come.
It is rarely wise to place all one’s chips on such a bet. There are far too many unknown variables to have absolute certainty as to what the future holds, and some of them can radically change future outcomes.
Were the U.S. government to unleash trillions more in fiscal stimulus before the end of November, for example, the market picture would look very different than it did if, say, Congress authorized no stimulus at all until February 2021. That factor alone could swing the verdict in the direction of “top” or “no top.”
For instance, on the one hand, Robinhood traders could pile back into their favorite stocks with a vengeance if given the chance to gamble with stimulus checks a second time.
On the other hand, a multi-month absence of fiscal pandemic relief, coupled with spiking hospitalization rates in dozens of states, could send the real economy over a fiscal cliff, dragging the stock market down with it to the point that bullish tech-stock sentiment never recovers.
As such, beyond the election result itself, fiscal stimulus or no fiscal stimulus is the big X-factor here, but the fiscal stimulus dynamic depends on post-election congressional action — and how do you map post-election congressional action on a price chart?
You can’t, not really — and there are many unmappable events like this that make true certainty impossible. Again, the future cannot be known with certainty when critical market-moving factors cannot be guaranteed.
Instead, the tools of the trade are odds and probabilities, coupled with an ability to move quickly as needed in the presence of uncertainty, whether that quick movement means cutting risk or jumping on a new opportunity.
The rational path forward in the presence of irreducible investment uncertainty is to work with the odds, and adjust for probabilities, and make portfolio decisions in real time as new information comes to light.
Risk management is foundational to this process. In that sense, the risk management process functions like a world-class set of brakes on a sports car. The brakes let the car go faster without crashing.
So, with the above said, if asked whether we think the top is in for technology stocks, the honest and rational answer is: “We don’t know — it depends on the timing and magnitude of future events — but it is certainly possible.”
There are other factors, like how much the pandemic intensifies with the onset of winter, and hidden aspects of market structure and margin-call impacts, that could further play a crucial role in determining whether tech stocks have topped.
But the case is certainly worth revisiting and exploring, and not just because a particular hedge fund manager is making it. While you can’t have certainty, an understanding of odds and probabilities can be just as useful. Professional investors, like professional poker players, act profitably in the face of uncertainty on a regular basis.
Then, too, there are other wise and experienced market observers, and respected research houses with decades of experience, who have made related observations that suggest the possibility of a tech-stocks top.
The top-calling hedge fund manager described above is David Einhorn of Greenlight Capital.
For many years, Greenlight Capital was seen as one of the most successful value-oriented hedge funds on Wall Street.
In its early years, Greenlight also developed a reputation for profitably shorting financial frauds, making money on the bear side as well as the bull side. Einhorn’s peak of fame and influence came in the aftermath of the global financial crisis, as he had been an early and vocal bear on Lehman Brothers before it collapsed.
In Greenlight’s latest quarterly letter to investors, Einhorn made the case for why technology stocks are in an “enormous” bubble, and why the market likely topped on Sept 2.
Einhorn also admitted to a top-calling error four years ago, when Greenlight made a comparable top warning for technology stocks in 2016. Einhorn’s rationale for the 2016 top call was that investors would not want to repeat the insane mistakes of the 1998-2000 period. “Clearly we were mistaken,” he said.
Einhorn and others have noted that, in order to call a top, or otherwise say a bubble has popped, you need more than just extreme valuations. You need investor behavior that is mania-like, or even downright nutty.
The action in tech stocks fits this bill. On Sept. 2 — the day Einhorn thinks was the top — TradeSmith Daily published our thoughts on “The Meaning of Tesla,” reflecting on how Tesla’s valuation was so nuts, Tesla investors would need to anticipate self-driving cars on Mars, or something to that effect, to have a hope of getting their money back.
Then, too, the whole “SPAC” trend has reached a point of sublime ridiculousness.
SPAC stands for “Special Purpose Acquisition Company,” which is a fancy way of describing a large pile of money to buy something unknown, or, alternatively, a publicly traded shell that allows a company to go public without the rigors of an IPO process.
If you want to take a company public quickly, but you don’t want too much scrutiny, the way to do it is to throw the thing into a SPAC. You find some lifeless company that has a functional stock ticker on an exchange, and you use it as a wrapper, and boom, you have a publicly traded stock for hyper-bullish investors to throw money at.
Or, if you have a vision in the spirit of the South Seas bubble, “for carrying on an undertaking of great advantage; but nobody to know what it is” — that was the actual 18th century description used — then you slap together a SPAC vehicle and get investors to send you hundreds of millions to billions to buy something you like.
We are now hearing about so many SPACS, even musicians and professional athletes are getting in on the game. This is goofy, nutty behavior. Einhorn is right about that.
In addition to this, we have seen top markers like entire industries going crazy (electric vehicle plays come to mind), stock splits leading to manic price run-ups (Apple and Tesla in late August), and an alarming embrace of leverage via near-dated call options (part of the Robinhood phenomenon).
Last but not least, you have what Ned Davis Research calls “the Elite Eight” trading at valuations that are beyond extreme. The Elite Eight are Apple, Amazon, Alphabet, Facebook, Tesla, Nvidia, Microsoft, and Netflix.
In the Sept. 18 TradeSmith Daily, “Why the FANG Stocks Will Start Trading Like Commodities or Currencies, For Years to Come,” we noted the following:
“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.”
The “Elite Eight,” as Ned Davis describes them, are subject to such extreme valuations that their share prices could fall by a third to a half without a material negative change to their business bottom line — and in so falling they would merely go back to where they were historically, before things started to get crazy.
This doesn’t have to happen, of course. The top may not be in, and the wildness may continue. But in seeing the likelihood of a tech-stocks top, the point is that Einhorn and others could be right, and have a significant body of evidence that suggests they might be right.
As an investor, what to do about this? The first job is to preserve capital, which is a matter of risk management. With capital preserved and risk management protocols in place, the second job is to go where the opportunity resides, and find other things to invest in even if tech stocks have topped.
In TradeSmith Decoder, we remain long Amazon, for example, and still have substantial profits on our core Amazon (AMZN) position established earlier this year. But we also took meaningful profits on a portion of our Amazon exposure months ago, and maintain a risk point on the core position to protect profits if the Amazon chart deteriorates.
It’s a similar story for silver (SLV), where we built a large position starting shortly after the March 2020 lows, and then added substantially to the position later: We have taken a large chunk of profits off the table with silver, and have a profit-protective risk point on the remaining core.
Part of the idea here is to use risk management in conjunction with opportunity awareness to avoid being forced into an all-or-nothing stance. There will be opportunities long and short no matter what the market does, and the most rational path of action will be responding logically to odds and probabilities whether a top materializes or does not.
The one thing you absolutely do not want to do, however, is find yourself subjected to “analysis paralysis” and holding stock positions into the depths of new downtrends. Given the non-trivial possibility that Einhorn is right, and that tech stocks may in fact have topped, that could be a recipe for disaster.