Has the market run too hard?

Who would have thought that, just four months after the market’s March nadir, many stocks would not only have recovered, but be at new all-time highs? Or that businesses like Afterpay, which has still to turn a profit, would be trading at such lofty prices? The big question is: how long can this unbridled enthusiasm continue?

Much of the strength has been driven by optimism for technology companies. In many cases, the thesis for buying technology makes sense; Microsoft for example, will benefit from the increasing number of people working from home. The strength in many reputable and profitable technology companies is therefore confirmation of the belief that this pandemic will be around for much longer than current mainstream commentary seems to suggest.

But if that’s the case, is the stock market’s enthusiasm rational?

While the thesis for buying technology might be rational, paying any price to gain exposure to that theme is irrational.

Keep in mind of course all booms start with a legitimate and credible thesis. As that thesis gains momentum, many less sophisticated investors jump aboard and eventually investors pile in not on the basis of the original thesis but simply because the shares keep going up. Eventually prices become so extreme they bear no relationship to reality and a bubble has formed. I believe we are there today, not for all stocks but for many in the technology space.

For an insight into the real and present madness of crowds just take the Buy Now Pay Later leader Afterpay. It’s share price is up almost eightfold since March, thanks in part to COVID-19 accelerating online and cashless retail sales, while government employment support programs both here and in the US ensured millennials could meet their repayment obligations to the company. Share price support was also aided by speculation of a takeover with the appearance of the Chinese company Tencent on the register.

Afterpay now has a market capitalisation of $19 billion, which is high for a company generating $230 million of revenue and a bottom-line loss. At the time of writing Afterpay is the 18^th largest listed company in Australia – bigger than Cochlear, Sydney Airport, Aristocrat, Brambles or shopping centre owner Scentre Group formerly Westfield. It’s bigger than Bluescope, Qantas and Lendlease combined. I am sure its two founders never envisaged this kind of reception when they were pitching the idea. Indeed, that’s perhaps why they recently sold $270 million worth of shares in their second sell down in 12 months – that’s more than the revenue the company generated. And if they’re selling now it makes you wonder how convinced they are of a takeover by Tencent at current or higher prices.

As I have said before, Afterpay is a factoring company. It buys a retailer’s receivables or debtors for a fee and then collects the amount owing directly from the debtor. Factoring businesses make small margins which partly explains why this company will have to keep raising money and diluting shareholders to fund its expansion. It has been raising money since Sir Ron Brierly’s ASX-listed Mercantile Investment Company bankrolled an $8 million raising for Afterpay in 2015 prior to its 2016 listing and it just raised another $800 million.

Highlighting the irrational exuberance in technology shares is not the only reason for mentioning Afterpay.

The company’s exposure to millennials, many of whom are without jobs, and recipients of government lifelines, raises the question of how long these government programs might continue. And that of course depends on the vagaries of the pandemic.

So, we have an economic crisis and a health crisis. Can it only be the absence of a financial crisis that is justification for such high stock market multiples? Recessions have a negative impact on company revenues and profits and I fear history will show there is nothing unique about this recession’s impact on the stock market. Companies go broke and the equity in those companies becomes worthless.

Government support programs are going some of the way to support consumption, but one must question the sustainability of the fiscal support needed just to keep the economy gasping for air, given massive government debt.

Meanwhile, central banks' conventional and unconventional monetary policy can only keep a company’s interest rates low. Monetary policy at the zero bound cannot bring a failing company new customers. It cannot deliver revenue. Consequently, it is reasonable to expect much higher levels of bankruptcies and defaults than we have already seen. As these businesses begin to fall over, many employees who currently expect to go back to work will not have a job to return to.

Some of those collapsed businesses will of course be purchased by private equity but even then, they will run a fraction of the stores that existed in 2019 or a fraction of the routes flown in 2019 (see Virgin Australia).

For professional investors it is time to be cautious. No fund manager or analyst can see the shape of employment and therefore consumption because government largesse in the form of wage subsidies has replaced wages of those furloughed. Spending patterns must and will therefore change. Predicting those changes while government handouts remain in place is next to impossible.

Investors would be wise at this juncture to consider whether expectations of an imminent end to the pandemic are premature. If first and second COVID-19 wave sends cities and countries back into lockdown and keep borders closed, then the unbridled enthusiasm currently gripping markets is equally misplaced and premature. It is therefore worth considering what is not currently expected and at least acknowledge that fat tail risk.

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