Stocks rallied again on Friday after a somewhat tepid employment report convinced investors that the Fed would lower rates again at the end of October. I have counseled many times that there is only one way to look at these monthly reports. A big gain in jobs is good. A small gain or a loss of jobs is bad. Friday’s report was somewhere in the middle, certainly not a figure normally worth a 1.5%+ gain in equity values. But given the weaker-than-expected economic data earlier in the week, a number within the range of expectations was a relief. In addition, equity investors are addicted to low rates. If sloppy data increases the odds of another rate cut, that would seem to enhance values.
Neither I nor anyone else can say today with conviction that we will or won’t enter recession next year. We can say with some degree of certainty that the economy is growing more slowly today than it has in the recent past. On the plus side, continued employment growth and strong consumer spending worldwide suggests that recession will be averted. On the other hand, investment is down, confidence is drifting lower, and policy uncertainty, particularly related to tariffs, has everyone confused and a bit concerned. The Fed may continue to cut rates and that will undoubtedly help. But rate cuts alone may not be enough to reverse trends, especially if China and the U.S. cannot come to some sort of trade truce in the fourth quarter.
Earnings season is close at hand. Results should resemble those of the past several quarters, a bit ahead of measured expectations. But, as always, it is the forward-looking guidance that is most important. Given that the fourth quarter is normally the most important of the year, guidance this time around will be especially important. With that said, industrial companies, commodity producers, and multi-national companies most impacted by trade policy will have a tough time being assertive and optimistic given all the uncertainties in front of us. Another round of tariffs is due to be implemented early next week. This round has already been postponed once, allegedly in deference to the 70th anniversary celebrations in China at the start of October. Without some progress between now and then, it would seem likely these tariffs will be initiated and markets would not like that.
Thus, the near term outlook is cloudy enough that it seems unlikely that stocks will move quickly to new highs unless earnings offer a big upside surprise. I should note that bond yields across the curve have come down quite a bit over the past couple of weeks. The 2-10-year Treasury spread is now positive again by more than 10 basis points and the 3-month to 10-year negative spread, which has averaged over 40 basis points for several months is now down to less than 15 basis points. Should the Fed lower rates in October, it could possibly end its rate inversion. That would be viewed positively, but the drop in rates across the curve is the bond market’s expression of slower growth, no recession, and inflation missing in action.
There are many who suggest that the bull market is long in the tooth and, perhaps, coming to an end. Slower growth helps to support that conclusion. So does the fact that this is already the longest bull market in history. But there is no rule dictating that bull markets have to end at any time. Australia, for instance, has avoided recession for over 25 years. Bull markets often (usually?) end with a bout of euphoria. We really haven’t seen that this time around. Sure, there are individual stocks that have invited speculative interest and whose market value is far apart from intrinsic value. But one-offs don’t define a euphoric state. There has been an active new issue market this year and there have been some very notable hot new names. But there have also been some high profile disasters and that doesn’t count the We disaster that had to be pulled before the public offering could be executed.
I would contend, however, that right before our eyes there have been not one, but two massive bubbles that have formed and both are set to burst, if they haven’t already.
The first is the private equity market. Just a few months ago, We, which leases slicked up temporary office space mostly to young emerging entrepreneurial companies, was valued in private markets at close to $50 billion. Today, that valuation is closer to $10 billion and survival through 2020 isn’t a certainty. Without new financing, the company won’t survive. We may be the highest profile failure but there are many others. There are over 150 companies private, with no stock in public hands, that are valued, based on their last financing rounds, at more than $1 billion. A few are valued at over $25 billion. Some are profitable. Most are not. Many have no reasonable path to profitability. For some that do, valuations make no sense no matter what valuation model one chooses to use. Two of the highest profile names that did come public, Uber and Lyft, both in the neo-taxi business, try to present themselves as disruptors that will be the next Amazons. Assuming a lot of ifs fall into place, that could happen, but it may be more likely that their supposed respective paths to profitability never reach that pot of gold at the end of the rainbow. Taxi service is both a commodity and highly competitive. Price matters. These companies can’t stop investing and suddenly be profitable. Yes, if they reach a certain size and scale, profits are possible. Yes, if there is a future for autonomous vehicles without drivers, the economics start to work. That is the hope of current investors. But there is little assurance either company is the ultimate winner. In an autonomous world, the drivers (and their costs) disappear, but they are replaced with the capital costs of owning a fleet of self-driving cars.
If you remember the Internet bubble of the late 1990s, I would suggest only Amazon became a superstar company in the long run. All the others failed to live up to promise. Most failed altogether. The big difference between then and now is that most of the 1990s failures happened in the public marketplace. This time around, most of the failures will be in the private marketplace as the vast majority of unicorns have not come public yet and, as noted, several that have failed to live up to expectations. The two worlds, are not that much different. Both gave birth to exciting ideas. Most fail, but several become very successful. In the euphoric stage, which I argue peaked earlier this year, valuations were woefully extended. From here forward, the carnage will start to get worse. Yes, there is still time for some with true paths to profitability to come public. But for most, they will either fail or their extended valuations will have to reset materially lower. Most venture capital and private equity investments are made via limited partnerships and funds with life expectancies of less than 10 years. Investors in these funds are not long term investors; they want to see exits. If the public markets become restricted to those either profitable or with clear paths to profitability, the remaining exit opportunities are to be sold to larger companies at rational prices.
This time around, private companies waited too long to go public. They wanted the sweet spot of market appreciation for themselves. If several had come public earlier, their initial valuation might have been less, but the exit doors would have been open. If there is a recession or bear market over the next 12-18 months, the exit doors will slam shut completely.
This is just one bubble.
The other is in the bond market. Bonds are supposed to reflect inflation expectations plus a small real return to compensate investors for the risk of ownership. There is no logic that supports the notion of negative interest rates unless one wants to assume persistent deflation over the life of a bond. With unemployment at 3.5% and wages rising 3% annually, there is no logic for imminent deflation, even if you accept my argument for worldwide oversupply and lower commodity prices. In the U.S. that is particularly true because we have converted to a services-based economy from a manufacturing base since World War II. Services have a much higher labor component. Pick whatever inflation number you want. A 1.5% 10-year Treasury simply doesn’t given owners a real return. That isn’t sustainable. Obviously, the negative interest rate environment in Europe and Japan is even more non-sensical.
So, why would anyone buy a bond with a negative interest rate. One reason is if the buyer expected negative sentiment to get worse, leading to rates becoming even more negative. The other would be if one expected a world where deflation would be so severe that the pace of price deceleration exceeded a bond’s negative return. Both explanations are stretches.
Bubbles burst when they get so large that the outer membrane has to burst. The failure of We to go public has now eliminated the opportunity for companies without a path to profitability to go public. The next step is to rationalize the values of IPOs of companies that may offer such a path. As we all know, when bubbles burst, the air escapes quickly. As for the bond market, there suddenly seems to be universal acceptance that moving rates even further into negative territory is counterproductive and of no economic value. It is just a matter of time before the negative rates disappear, and bonds once again are priced to give buyers a real return above the rate of inflation.
When a hurricane hits, the last place you want to be in is the path of the eye. At the fringes, there can still be damage, but it won’t be intense. In financial markets, the eyes are the private equity and bond markets. The stock market is impacted but at the fringes. Since World War II, the average recession has seen about a 13% decline in profits and a 20% decline in equity valuations. 2008 wasn’t typical; it just left behind the greatest amount of fear. If a mild recession does occur (and that remains a minority view), it should be short and the damage will be limited. There is a large cloud out there in the future that centers around the massive buildup of debt, but for that storm to turn into a hurricane, interest rates have to be much higher than they are today. In hurricane watcher terms, know the storm is out there, but it is more than 2,000 miles away.
Today, Simon Cowell is 60. Yo-yo Ma is 64. Vladimir Putin turns 67.
James M. Meyer, CFA 610-260-2220