Stocks fell sharply yesterday morning, but recovered much of their losses throughout the day as traders continued to worry whether the U.S. would raise tariffs on China.
12:01am has now passed, and the tariffs are on, at least for now. Supposedly Presidents Trump and Xi are going to have a phone call later today. The first of two binary options is that they will kiss and make up, a trade resolution will be close at hand or agreed to in principal, and everyone will go home for the weekend. The second is that they won’t find common ground, the tariffs will stick, and Mr. Trump will threaten even more tariffs as soon as 90 days from now.
Futures in the wee morning hours are flat to slightly lower, an indication traders expect negotiations to find common ground soon or a belief that at least this round of tariffs won’t have much of an economic impact. China’s markets were up 3% overnight, hardly a belief that whatever happens in the short run will sink their economy.
Obviously, I have no answers, only guesses, and my guesses are worth no more than anyone else’s. Whether there is a deal today or soon, the expectation, at least for now, is that there will be some sort of settlement or compromise that will allow economies worldwide to stay on course. I have no reason to argue with the consensus.
But a bigger question is whether trade and tariffs are the only dominant market drivers at the moment or whether other forces are at work. After a 17% rise in the first four months of the year, it would be an easy market to say stocks have gone too far too fast no matter how optimistic one is about trade talks. I buy into that theory. It doesn’t make me bearish, and it certainly doesn’t make me negative on the economy in any way. It simply means stocks may have come too far too fast and that is the setup for a correction.
There might be another factor in play. The Uber IPO was priced last night at $45, and will begin trading today. After the weak reception for Lyft, which is now selling for more than 30% below its own IPO price, investors are a bit skittish about the Uber offering. With that said however, there have been a bunch of other IPOs recently that have been hot including names like Pinterest, Zoom Video, and Beyond Meat. The one commonality is that they are all companies that are still losing money or barely profitable.
This IPO is different from all that preceded. Companies are coming public much later in life. Therefore, they are much larger in size, at least as measured by revenues. They are also valued much higher than names like Amazon and Netflix, which both came public with total enterprise values of under $500 million. When Amazon came public, it sold books over the Internet. There was no cloud or even a thought of cloud services. That was to evolve later. Netflix primarily was a company that sent you movie discs through the mail. Streaming was in the future. Obviously, both companies expanded nicely and became highly profitable over time. Public investors who bet on them made lots of money.
Uber and Lyft investors are betting that today’s ride sharing services will evolve as well once autonomous vehicles become standard, whenever that occurs. But these companies start with market caps measured in the tens of billions of dollars. The downside risk is enormous, and a lot of their future potential has to be priced in. As for the others, Pinterest has to separate itself from other social media names and increase its share of advertising support. Beyond Meat, now valued near $4 billion serving an industry that isn’t $1 billion in size yet, has to fight off other companies offering meat alternatives as well as giants already in the industry like Tyson Foods and Cargill. A $4 billion valuation isn’t a speculation of success; it is already a bet that Beyond Meat is going to dominate the category.
My point is obvious. While many say we aren’t in that frothy euphoric market period where valuation premiums get so high that they trip up markets, they may be getting fooled by the size and seasoning of the companies coming public. To say it bluntly, valuations of these deals are absurd, at least in my opinion, as it is only time before markets make the same conclusion. Unlike 1999, there aren’t a lot of public companies as absurdly valued, but there are some, mostly in the high-tech arena. There was an old saw, and it could have been applied to the high-tech winners of 1999 like Microsoft#, Intel and Cisco#, that once a stock sold at 10x revenues it was at an unsustainable valuation. There are many tech companies that are in the sweet spot today selling at 10x revenues or higher. Again, I am not knocking the companies; I am criticizing the valuations.
Thus, trade talk success or not, I think the real focus of the market in coming weeks or months will be on the bubble developing within the IPO market. There are other big name offerings that will follow Uber including possibly WeWorks and Slack. There are reasons all are trying to come to market now. Investment bankers sense that this maturing bull market might not last forever. If progressive Democrats win the 2020 election, stocks are likely to face a wall of worry, at least at the beginning. If the IPO window closes, the companies still waiting to go public may have to wait several more years. Most of the big names just discussed are companies that are now a decade old, some older. They were backed by investors who want and need to cash out. In coming months, owners of shares of Uber, Lyft, etc. will be free to sell their shares in the open market. They will find buyers. Buyers will have to take money from somewhere else to buy these stocks. I am talking about tens of billions of dollars. The end of these lock up periods are likely to weigh on valuation for months to come.
In summary I, like everyone else, hope that China and the U.S. resolve their trade differences. But as investors, I am more concerned about the bubble emerging in the IPO marketplace. Perhaps a weak reception for Uber will temper the enthusiasm. But I don’t think so. Bankers want to get these deals done, and early private investors do as well. Valuations today may be 10-20% below what they would have been several weeks ago, but they are still way too high. The real worry won’t be evident today; it will come as the lock up periods end and billions flow out of other investments into these new names. Can Uber be the next $500 billion mega giant? Sure, it could. It hopes to be worldwide in scale dominating an emerging business that has enormous potential. I could have said the same thing about Amazon 20 years ago. But I also could have said the same thing about AOL. That’s the risk Uber investors are taking. But when you start with a valuation of $50-100 billion instead of less than $1 billion, the risk-reward equation is quite different.
Today, Bono is 59.
James M. Meyer, CFA 610-260-2220