This is a syndicated repost courtesy of David Stockman's Contra Corner » Stockman’s Corner. To view original, click here. Reposted with permission.
The inexorable effect of contemporary central banking is serial financial booms and busts. With that comes increasing levels of systemic financial instability and a growing dissipation of real economic resources in misallocations and malinvestment.
At length, the world becomes poorer.
Why? Because gains in real output and wealth depend upon efficient pricing of capital and savings, but the modus operandi of today’s central banking is to deliberately distort and relentlessly falsify financial prices.
As we have seen, the essence of ZIRP and NIRP is to drive interest rates below their natural market clearing levels so as to induce more borrowing and spending by business and consumers.
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It’s also the inherent result of massive QE bond-buying where central banks finance their purchases with credits conjured from thin air. Consequently, the central banks’ Big Fat Thumb on the bond market’s supply/demand scale results in far higher bond prices (and lower yields) than real savers would accept in an honest free market.
The same is true of the hoary doctrine of “wealth effects” stimulus. After being initiated by Alan Greenspan 15 years ago, it has been embraced ever more eagerly by his successors at the Fed and elsewhere ever since.
Here, the monetary transmission channel is through the top 1% that own 40% of the financial assets and the top 10% that own upwards of 85%. To wit, stock prices are intentionally driven to artificially high levels by means of “financial easing”. The latter is a euphemism for cheap or even free finance for carry trade gamblers and implicitly subsidized hedging insurance for fast money speculators.
As the stock averages rise and their Fed-subsidized portfolios attain ever higher “marks”, the wealth effects operators supposedly feel, well, wealthier. They are thereby motivated to spend and invest more than otherwise, and to actually double-down on these paper wealth gains by using them as collateral to obtain even more cheap funding for even more speculations.
The trouble is, financial prices cannot be falsified indefinitely. At length, they become the subject of a pure confidence game and the risk of shocks and black swans that even the central banks are unable to off-set. Then the day of reckoning arrives in traumatic and violent aspect.
Exactly that kind of Lehman-scale crisis is now descending on global markets. In fact, it’s even worse. Speculative excesses that are even more fantastic than during the dotcom era mania have now infested the technology and social media stocks,.
So once again the end result of today’s massive central bank intrusion in financial markets will be yet another thundering crash of the high flyers and a resulting financial crisis of unprecedented extent.
The Folly Of The FANGs
Needless to say, there have been some spectacular rocket ships in the market’s melt-up during the last several years. But if history is any guide this is exactly the kind of action that always precedes a thundering bust.
To wit, the market has narrowed down to essentially four explosively rising stocks—–the FANG quartet of Facebook, Amazon, Netflix and Google—–which are sucking up most of the oxygen left in the casino.
At the beginning of 2015, the FANG stocks had a combined market cap of $740 billion and combined 2014 earnings of $17.5 billion. So a valuation multiple of 42X might not seem entirely outlandish for this team of race horses, but what has happened since then surely is.
At the end of August 2016, the FANG stocks were valued at $1.3 trillion, meaning they have gained $570 billion of market cap or nearly 80% during the previous 19 months. Not only has their combined PE multiple escalated further to 50X, but that’s almost entirely owing to Google’s far more sober PE at 30X.
By contrast, at the end of August 2016, Netflix was valued at 300X its meager net income of $140 million, while Amazon was valued at 190X and Facebook at 60X.
In a word, the gamblers are piling on to the last trains out of the station. And that means look out below!
An old Wall Street adage holds that market tops are a process, not an event. A peak under the hood of the S&P 500 index, in fact, reveals exactly that.
On the day after Christmas 2014, the total market cap of the S&P 500 including the FANG stocks was $18.4 trillion. By contrast, it closed at $19.0 trillion in August, reflecting a tepid 4% gain during a 19 month period when the stock averages were spurting to an all-time high.
Needless to say, if you subtract the FANGs from the S&P 500 market cap total, there had been virtually no gain in value at all; it was still $17.7 trillion.
So there you have it—-a classic blow-off market top in which 100% of the gain over the last 19 months was owing to just four companies.
Actually, there is growing deterioration down below and for good reason. Notwithstanding the FOMC’s stick save at nearly every meeting during the past two years, each near miss on a rate hike reminded even Wall Street’s most inveterate easy money crybabies that the jig is up on rates.
Sooner or later the Fed will just plain run out of excuses for ZIRP, and now, after 93 straight months on the zero bound, it clearly has.
And at the most inopportune time. As we demonstrated earlier, the world economy is visibly drifting into stall speed or worse, and corporate earnings are already in an undeniable downswing. As we have also indicated, reported EPS for the S&P 500 during the LTM ended in June 2016 came in at $87 per share or 18% below the $106 per share reported in September 2014.
So the truth is, the smart money has been lightening the load during much of the last two years, selling into the mini-rips while climbing on board the FANG momo train with trigger finger at the ready.
Chasing The Last Momo Stocks Standing—- An Old Wall Street Story
Needless to say, this narrowing process is an old story. It famously occurred in the bull market of 1972-1973 when the impending market collapse was obscured by the spectacular gains of the so-called “Nifty Fifty”. And it happened in spades in the spring of 2000 when the Four Horseman of Microsoft, Dell, Cisco and Intel obfuscated a cratering market under the banner of “this time is different”.
But it wasn’t. It was more like the same old delusion that trees grow to the sky. At its peak in late March 2000, for example, Cisco was valued at $540 billion, representing a $340 billion or 170% gain from prior year.
Since it had earned $2.6 billion of net income in the most recent 12 month period, its lofty market cap represented a valuation multiple of 210X. And Cisco was no rocket ship start-up at the point, either, having been public for a decade and posting $15 billion of revenue during the prior year.
Nevertheless, the bullish chorus at the time claimed that Cisco was the monster of the midway when it came to networking gear for the explosively growing internet, and that no one should be troubled by its absurdly high PE multiple.
The same story was told about the other three members of the group. During the previous 24 months, Microsoft’s market cap had exploded from $200 billion to $550 billion, where it traded at 62X reported earnings. In even less time, Intel’s market cap had soared from $200 billion to $440 billion, where it traded at 76X. Dell’s market cap had nearly tripled during this period, and it was trading at 70X.
Altogether, the Four Horseman had levitated the stock market by the stunning sum of $800 billion in the approximate 12 months before the 2000 peak.
That’s right. In a manner not dissimilar to the FANG quartet during the past year, the Four Horseman’s market cap had soared from $850 billion, where it was already generously valued, to $1.65 trillion or by 94% at the time of the bubble peak.
There was absolutely no reason for this market cap explosion except that in the final phases of the technology and dotcom bull market, speculators had piled onto the last momo trains leaving the station.
But it was a short and unpleasant ride. By September of 2002, the combined market cap of the Four Horseman had crashed to just $450 billion. Exactly $1.0 trillion of bottled air had come rushing out of the casino.
Needless to say, the absurdly inflated values of the Four Horseman in the spring of 2000 looked exactly like the FANG quartet today. The ridiculously bloated valuation multiples of Facebook, Amazon and Netflix speak for themselves, but even Google’s massive $550 billion market cap is a sign of the top.
Despite its overflowing creativity and competitive prowess, GOOG is not a technology company which has invented a rocket ship product with years yet to run. Nearly 90% of its $82 billion in LTM revenues came from advertising.
But the current $575 billion worldwide advertising spend is a 5% growth market in good times, and one which will slide back into negative territory when the next recession hits. Even the rapidly growing digital ad sub-sector is heading for single digit land; and that’s according to industry optimists whose projections assume that the business cycle and recessions have been outlawed.
The fact is, GOOG has more than half of this market already. Like the case of the Four Horseman at the turn of the century, there is no known math that will allow it to sustain double digit earnings growth for years into the future and therefore it 30X PE multiple.
Likewise, Amazon may well be effecting the greatest retail revolution in history, but its been around for 25 years and still has never posted more than pocket change in profits. More importantly, it is a monumental cash burn machine that one day will run-out of fuel.
During the LTM period ending in June 2016, for example, it generated just $6.3 billion of operating free cash flow on sales of $120 billion. So it was being valued at a preposterous 58X free cash flow.
So here’s the thing. The Four Horseman last time around were great companies that have continued to grow and thrive ever since the dotcom meltdown. But their peak valuations were never remotely justified by any plausible earnings growth scenario.
In this regard, Cisco is the poster child for this disconnect. During the last 15 years its revenues have grown from $15 billion to nearly $50 billion, and its net income has more than tripled to nearly $10 billion per year.
Yet it’s market cap today at $150 billion is just 25% of its dotcom bubble peak. In short, its market cap was driven to the absurd height recorded in March 2000 by the final spasm of a bull market, when the punters jumped on the last momo trains out of the station.
This time is surely no different. The FANG quartet may live on to dominate their respective spheres for years or even decades to come. But their absurdly inflated valuations will soon be deFANGed.
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