Quarterly Newsletter October 1, 2018
Are We Reliving the 1990s?
If you were offered the chance to relive the 1990s all over again, would you? I realize the verb “relive” can take on two very distinct meanings: either to enjoy the era for a second time just as it was, or to live it differently than you did the first time. Probably, you would request to have it both ways…pick the best and change the rest. On many levels, I wouldn’t mind being in my 20s again, and the fact that flannel was cool also weighs heavily in my favor.
Since this is an investment newsletter, not a fashion newsletter, we’ll (try to) limit the comparisons to the stock market in both eras. The obvious similarity is the dominant role that technology has played. Tech stocks not only led the market in the last few years of the 1990s, they were the market in 1999 and early 2000. How much dominance? Even as the market roared to daily new records in the last 15 months of the bull market, most non-tech stocks actually fell. The tech sector rose 79% in calendar year 1999. In the 17 months from October, 1998 to the peak in March, 2000, tech rose a whopping 245%.
Despite the headline-grabbing performance of tech stocks in the last couple years, the disparity between tech and non-tech isn’t nearly as jarring this cycle, but the similarities are there. Tech leads among sectors this year, +20%, but consumer discretionary and health care (you read that correctly) are not far behind at +18% and +15%. As we write this, the S&P 500 is +9% for the year. Five sectors are actually in the red in 2018. Four of those are highly sensitive to changes in interest rates (which have gone up quite a bit this year)—telecom, utilities, real estate, and consumer staples—with materials also sagging this year. The same thing happened in 1999 (although real estate was not a standalone sector then).
So does it sound the same, or smell the same?
“The Most Boring Bull Market”
Whichever sense you prefer, the feel of this era is very, very different from the 1990s in at least one big way: the level of euphoria in the stock market. It has been said that the bull market that began 9 ½ years ago has been either the most hated or the most boring bull market ever. Generally speaking, we at Monarch have very much enjoyed this bull market, but certainly would agree that these monikers are accurate representations of the consensus opinion. Having been stung by two horrible bear markets in the same decade, many investors who “got burned” swore off ever owning stocks again. Even after the market had been rising for years, investors continued to shovel money into bond funds, believing bonds to be safer (they are less volatile, at least). Meanwhile, baby boomers are being told they need more bonds, and millennials have also been scared to invest. A recent report from UBS showed that millennials hold 52% of their savings in cash, compared with 23% in other age groups.
The data on flows into mutual funds totally bear this out. We have been updating and publishing fund flow data for 15+ years because, in our minds, it gives us the best look into investor sentiment. When investors are the most confident in stocks, they put the most money into stock funds. This is useful because there is a strong negative correlation between the amount of inflows into stock funds and the stock market performance the following year. It is very reliable, and it is statistically significant. The chart below shows the cumulative amount of money (in $ billions) that has flowed into U.S. stock funds, international stock funds, and bond funds, since 2008. When the line is falling, that means more investors are taking money out of funds than investors putting money into them. These totals include all kinds of funds—actively managed funds, index funds, mutual funds, ETFs.
Focusing on the dark line on the bottom, you see that it’s pretty much always going lower, with the exception of 2013-2014, and briefly in late 2016 after the election. In 2018 alone, net outflows from U.S. stock funds have totaled $75 billion. We are constantly trying to figure out why investors aren’t putting more money into U.S. stocks, and how the market can continue to rise despite this apparent headwind. We also wonder if we’re missing something, but since the correlation continues to be strong (years with outflows lead to good markets the next year and years with inflows—2013 and 2014—led to the correction of late 2015-early 2016), it doesn’t seem wise to bet against it.
We have also poured considerable energy into figuring out the conundrum of why stocks can rise without the participation of either retail investors or financial advisors who use funds for their clients. We believe that foreign investors have increased their holdings of American stocks, perhaps because our market has continually outperformed European markets. Interestingly, American investors continue to pour money into international stocks (see the blue line above)….despite the same reason? Companies have bought back a lot of stock in this bull market. Institutional investors have been a toss-up; there has been no visible movement toward U.S. stocks by pension funds, university funds, foundations, or consultants, after being so underweight stocks. Hedge funds have probably shifted more money into stocks because their performance has been so miserable every year since 2008, so they need to “catch up” in order to justify their exorbitant fees and keep investors from flying the coop.
We have come to the conclusion that the biggest reason for higher stock prices has been….lower supply of stocks! Remember supply and demand? If you haven’t caught on yet, I love writing about supply and demand (see past October newsletters). If supply of a product shrinks, price must go up if demand is unchanged, because there would otherwise be too much demand that could not be satisfied. As price goes up, demand drops to match up with the lost supply (kind of makes sense now, as you consider the chart on page 2…that lower demand for stocks went instead into bonds, where supply has grown rapidly).
But what does it mean that supply has dropped? It means that the number of publicly-traded companies has dropped, and it also means that the number of shares of companies that remain public has dropped. We included a graph in last October’s newsletter, showing the “divisor” of the S&P 500, or the number of shares outstanding for those 500 companies. It has fallen 6% since 2011. Shares outstanding drop when companies buy back their own stock, or if they get acquired and go private. Shares outstanding rise when companies issue more of their own stock, or if they go public (via an Initial Public Offering, or IPO). While there have been some IPOs this cycle, they have been overwhelmed by companies going private or buying back stock. Lest you think this is normal, shares outstanding rose during the 1990s by 35%. That makes you wonder how it was possible for the stock market to do so well in the 1990s when supply was increasing so rapidly. The answer: demand increased even more.
Which brings us back to the original issue: the level of euphoria. New highs in the market in the 1990s were met with celebrations and confetti on the NYSE trading floor. People threw parades when the stock market hit milestones like Dow 10,000. Nowadays, record highs, milestones, and incredible feats like in August when the bull market became the longest bull market ever (passing the 1990s) are met with…crickets. That may be generous; we actually see an uptick in questions from people wondering if they should pare back stocks since stocks are at their “peak” (“peak” and “new high” seem to be interchangeable terms these days). While that’s anecdotal evidence, not hard evidence, it is corroborated universally by anyone in this business.
The Evolution of Private Equity
The lack of euphoria is baffling on the surface, but it becomes understandable if you dive into the world of private equity. Questions suddenly get answered. Why isn’t there more euphoria, more froth, more bubbliness in the stock market, 10 years into a bull market that should have been emboldened by a Goldilocks economy (not too hot, not too cold) that has proven to be so durable? Answer: the bubbliness has been mostly confined to private equity.
What is private equity? Simply, it is the ownership of businesses that are not publicly-traded on an exchange. This includes virtually all small businesses. But the vernacular “private equity” has more to do with the fund groups which take in client money and invest it into privately-held companies. There are two main subsections within private equity: buyout funds and venture capital funds. Buyout funds typically buy mature businesses with steady cash flows (and borrow a lot of money to buy them). Venture capital (VC) funds buy young businesses which need capital in order to grow. VC has been the hot area for gathering money in this bull market.
The chart on the next page shows the amount of money invested in private equity funds. Assets are split into two: the value of investments in those funds, and the amount of money raised from investors but not yet invested (dry powder). The sizable increase in assets over the years is due to higher valuations of portfolio companies, and also thanks to funds flowing into private equity.
Silicon Valley was alive and well in the late 1990s, and endured a tumultuous bust in the early 2000s, but its role in creating and funding startups is so much bigger now than then. 20 years ago, VC funding was used to bridge a startup from its launch phase to its going-public phase, and the faster that happened, the better. Founders were emboldened (and incentivized) to IPO their company as fast as humanly possible. The founder would be immediately rich (and admired), and able to attract employees much more easily if there was a path to an IPO, because those employees were looking for a quick payoff. And what better way to show off to the world that your company was successful than to have a stock shooting up? If you were privately-held, your company merely had potential. Thanks to those IPOs, the number of publicly-traded stocks rose sharply in the 1990s, but has fallen a lot since (see chart below).
Today, the role of private equity has transformed 180 degrees. Now, founders want to stay private as long as they can. The public markets have become a more hostile environment in many ways. First, regulatory burden of publicly-traded companies took a leap upward in the wake of the tech bust, jumpstarted by the famous Sarbanes-Oxley legislation (thank you, Enron). If you get a chance to ask Elon Musk how he feels about Tesla being publicly-traded, either he will go off on a tirade and kick you, or he will start crying. Secondly, investors in publicly-traded stocks can be downright mean. Look no further than activist investors. Activists typically buy a large number of shares of a company, then announce they have done so, then send a letter to management of the company calling for them to make a bunch of changes in the name of “increasing shareholder value.” Often, they call for the head of the CEO.
The founder of a successful startup enjoys much more job security in the cozy world of private equity. Every stakeholder’s objectives are aligned in this happy place; the higher the valuation of a privately-held company, the more everyone wins, both founders and funders alike. Who sets the valuation of privately-held companies? Not the free market; that’s too cruel. No, the valuation is set by the founders and funders themselves!
You might think I’m joking, if you’re not familiar with this world. Here’s how it works for a successful startup. The founder needs more capital in order to grow. He has already maxed out his credit card and friends and family network, and is willing to part with some of the ownership of his company. Venture capital funds line up to hear his pitch, and they make “offers” to buy into his company. The founder chooses the funders based on their reputations and the valuation they ascribe to his company. Fast forward 12 months. The startup is still growing and needs more cash, because the company is still not generating enough capital internally. The founder approaches the same VC funds to see if they want to pony up some more money, and maybe reaches out to some new funds to attract yet more money. The valuation of the company is typically marked up as high as possible, constrained only by the limit of how much money can be brought in by the funders. So technically, this process is influenced by supply and demand. If this company is still successful down the road and still needs funding, more VC funds get brought in.
VC funds are happy to see their investments become successful, and there are two ways to define success: show a rising value with each successive funding round, or exit strategies (the company is sold or goes public, so that the fund can sell its shares to the public). The VC world was merrily forgoing the second option because the first option was working so well. There was no end to the long line of funders willing to invest in startups at any valuation. The VC funds had a lot of money being shoveled at them by investors, and they were under pressure to get it put to work…witness the rising amounts of dry powder.
Hmm…a hot sellers’ market, rapidly rising prices, lots of new fast money trying to get in, a financial conduit to enable it. Sound familiar? Oh yeah, the housing bubble! Now, who’s to say those high and rising valuations were too high? Supply and demand! Somewhere along the way, VC funds wanted to see a path to getting their money (and profits) back. So they started pushing for more IPOs. Unfortunately, what they found was that the valuations that would be supported by the public markets were vastly below—sometimes small fractions of—the valuations they had applied to their companies in the last round of funding. This “reality check” phase began in earnest in 2015. In the midst of it, a nasty correction was taking place in the stock market in 2015-16, making the appetite for IPOs even smaller. Many of the companies that went public between 2011 and 2014 bombed (think: Groupon, Zynga, GoPro, FitBit, even Twitter) AFTER going public. Even Facebook’s IPO was an epic failure at first. The door for IPOs more-or-less closed, unless funders were willing to swallow their pride (and profits) and consider a “down round IPO,” going public at a valuation that was lower than their last private valuation.
In the wake of that wake-up call, privately-held companies grew even more wedded to the idea of staying private for a long time. They came to understand that there was no longer any justification for funders to apply higher valuations to their companies. Valuations were held flat with new funding rounds for many startups, although the number of down rounds (lower valuations for a new funding round) rose markedly as well. Funders have also come to grips with the new reality that they might have unwittingly become long-term buy-and-hold investors (welcome to the club!), although they are aware that their investors still want to get paid at some point.
Within the last year, the IPO “freeze” has thawed a little bit, especially for higher-quality companies, since the stock market has roared higher. Many IPOs have seen big pops in their stocks on the first day of trading, although many have also subsequently fizzled out, most recently Snap (owner of Snapchat), whose stock has fallen from a first-day high of $27 to $9. So, the valuation trap that the private equity industry laid for itself and then stepped into is still intact.
Why does this matter for the rest of us? First of all, this is yet more proof that, despite the fact that the stock market is somewhat expensive compared to history, it is still arguably the cheapest market around, if you consider private equity, bonds, cash, and real estate. Secondly, history teaches that bull markets generally end with some euphoria. Has the private equity bubble filled that role this cycle, or will we yet see a euphoric return of investors to publicly-traded stocks? This is one of many signposts we assess as to whether the bull market is near its end. None of the other signposts declare that we are. The risk of the Fed over-tightening on interest rates remains one of the biggest risks. Everyone is in a wait-and-see mode, including the bond market. While the yield curve is pretty flat, recently long bond yields have compliantly risen along with short bond yields; this is a good thing. With a strong economy and strong growth in profits that will almost certainly continue through next year, we could very well have another leg up in stocks, if only because of supply and demand for stocks. Bonds offer a lot more safety, but they still seem overbought compared to stocks.
Written by John Meyer