Stock prices are setting record highs. Bond yields are starting to recede. Bitcoin is over $100,000. Profits are rising and, hopefully, regulatory costs are set to decline. Is it too good to be true?
When something looks too good to be true, don’t you step back and pause?
In early 2021, euphoria set in. SPACs were the new new thing, publicly offered blind pools loaded with fees for the promoters. A very few actually found something to buy that made shareholders money. Some overpaid for junk, then headed to the graveyard. Others found nothing to buy and returned money to shareholders a couple of years later. Early 2021 was also the apex for meme stocks like GameStop and AMC movie theatres. Also Bed Bath & Beyond, now bankrupt. Too good to be true. The S&P 500 rose 27% that year before giving back over 19% in 2022 as euphoria gave way to skepticism.
At the top, I listed a lot of good news items that support investor optimism. But optimism and realism aren’t synonyms. The S&P 500 this year is up a bit above 28%. Profits are up closer to 10%. Once again realism is giving way to euphoria.
And the Fed isn’t helping.
The Fed sets interest rate policy looking at certain key metrics like the rate of inflation, GDP growth and changes in the money supply. Since mid-2022 inflation has moderated from a peak of about 9% to about 3% today. Economic growth is just under 3% adjusted for inflation. The money supply (M2) today is actually about 0.8% lower than it was in the spring of 2022. Thus, any observer could easily praise the Fed for keeping money rather tight as it continues to focus on economic growth and moderating inflation.
But that isn’t the whole picture. Inflation has stopped going down. While certain commodities like oil continue to slide in price, which is normal for this time of year, services inflation remains higher than desired, closer to 3% than 2%. While it’s true that money supply remains flattish, and the Fed Funds rate continues to be higher than the nominal rate of inflation, wealth has soared. Since mid-2022 U.S. wealth has risen by 12.8%. M2 actually declined over the same period. Why such a spread? Stock prices and home values. Thus, if you owned a home and a stock portfolio, you are a very happy camper at the moment. But if you don’t, you are struggling.
Big corporations can borrow in public and private markets at relatively low interest costs, especially after taking taxes into consideration. But small businesses have to pay 10% or more to borrow. Individuals “borrow” using their credit cards. They are often paying over 20%. Car payments today are double what they were two years ago in many cases. Thus, how the world is doing financially depends on what lens you are looking through.
Earlier I mentioned the euphoria centered on SPACs and meme stocks in early 2021. Today that euphoria has shifted to bitcoin. With the advent of ETFs that can invest in cryptocurrencies, billions of dollars of cryptocurrencies have been added to portfolios. The Trump administration is supportive of crypto, adding to the enthusiasm. But where is the tipping point between enthusiasm and euphoria?
Enter MicroStrategy. This is a public company whose value is tied to its bitcoin holdings. It’s an easy way for the small public investor to participate in the bitcoin boom without the headaches and high cost to own and store bitcoin. Indeed, owning MicroStrategy’s stock has become so popular that as of December 1, its stock price was more than double the value of its bitcoin holdings. How does MicroStrategy respond? Logically, it sells more stock at the 2x book value price and it also sells zero or near zero coupon convertible bonds at a conversion price significantly higher than its stock price. If you think this resembles a Ponzi scheme, it does. It works as long as there are avid buyers willing to pay twice what MicroStrategy’s underlying assets are worth. As for the bonds issued with near zero coupons, while there is little interest cost burden, ultimately those bonds will have to be redeemed.
The euphoria does stop there. There are now ETFs with close to $5 billion in assets that use derivates to try and leverage the gains and losses in MicroStrategy’s stock. The goal is to offer 2x leverage (which works both ways). That’s not the end of the story. If MicroStrategy can sell stock at twice the value of its bitcoin holdings, why can’t others do the same thing. Indeed, others are trying, including a notable mimic in Japan.
I know there are lots of arguments supporting the value of bitcoin. But, as of today, it isn’t a currency and its volatility suggests that it is a questionable store of value. Might the Trump administration buy bitcoin as a store of value supplementing or replacing gold reserves? Who knows? Bitcoin has its supporters who believe that it might replace gold as the primary alternative to a cheapening dollar in a nation that racks up $2 trillion annual deficits. But let’s put some perspective to the argument that bitcoin is going to be an alternative currency that might either replace the dollar or at least replace gold as a partial backstop to the dollar. The total value of bitcoin today is about equal to the value of gold held by the U.S. government, a bit over $500 billion. Trump talks about the possibility of bitcoin replacing, or at least supplementing, gold as a reserve. Maybe that will happen. To be sure there are lots of issues to be dealt with before that happens. I am not here to speak for or against bitcoin. Rather, I equate the bubble that is surrounding MicroStrategy and its imitators and leveraged derivatives to the meme stock and SPAC bubble of 2021. What I can’t forecast is when the bubble will burst. While bitcoin has more than doubled in value this year, with a large portion of that gain coming after the election, MicroStrategy’s stock is up over 550%.
We saw a bubble 3+ years ago with the meme stocks and SPACs. But this bubble is bigger. Bitcoin’s $500 billion in value excludes the value of other cryptocurrencies or any derivatives based on bitcoin. That is still a tiny fraction of U.S. net wealth of over $155 trillion, but a sudden change would cascade through markets. It’s also a tiny fraction of our money supply.
Just as was the case three years ago, no one can tell us when the bubble will burst. Bitcoin could easily double before any significant correction. But when you see distorted valuations as you see today with MicroStrategy and derivatives, some rationalization is inevitable. It also speaks to the mood of investors. Bitcoin isn’t the only asset that has soared recently, nor is it the only sign of euphoria. Given the regulatory barriers (and cost) erected to push major growth companies to stay private, more and more efforts are being made to allow “sophisticated” investors to buy shares of private companies. Think about this. Companies want to stay private to avoid the burden of regulation and disclosure. But they want the liquidity offered by these newer channels that broaden who can own their shares. You shouldn’t be able to have it both ways. This is exactly the escape route SPACs used in 2021 to issue blind pools and then invest in whatever, with limited disclosure. In my view, you either choose to limit disclosure and keep ownership within a tight ownership base, or you broaden ownership and disclose information in a reasonably consistent manner with public companies.
Everything I have just said could apply in 2021 or today. Don’t misread what I am advocating. Technological advances have created massively valuable new companies, most not public yet. The opportunities are enormous. But the huge increase in wealth is funding a speculative boom, one that has the elements of a bubble. What is happening with derivatives of bitcoin, feeding on the speculative fever, is starting to infect the overall market. The S&P is up 28% while profits are up just over 10%. MicroStrategy is up over 500% this year, twice the rise in bitcoin. In stock market cycles, euphoria is end stage. Judging from the 3-6 month futures of the VIX volatility index, I am not alone in my conclusions. Thus, while the economic outlook is built on optimism, when stocks trade at 23 times future earnings estimates, almost 50% above historic norms, caution is advised. I’ll end there.
Today John Malkovich is 71. Judi Dench turns 90.
James M. Meyer, CFA 610-260-2220