"Wha' happened?" The words of the immortal Mike LaFontaine of "A Mighty Wind," played by the recently and sadly deceased Fred Willard, have been pounding my brain this morning.
First, a benign open on the back of jobs numbers that were slightly better than expected. The Department of Labor reported that 1.37 million jobs were created in August; I had a consensus of 1.32 million jobs created. But by about 9:45 a.m., the market resumed its recent pattern of Nasdaq-selling.
How can this happen?
How can sentiment turn on a dime so quickly? Wednesday, the pundits were all hyping Nasdaq 12,000 and Friday we are struggling to hold 11,000, with Apple (AAPL) and Tesla (TSLA) leading the tech index to the red.
It's tempting here to be condescending and say "that's how markets work," but that is misleading. I am close to turning the page on my fourth decade of following this Wall Street insanity, so let me drop a little knowledge on you.
Moves like this week's are much, much more common when valuations are extended. Earlier this week, we hit a cycle-high valuation, with the forward price-to-earnings ratio of the S&P 500 reaching 23.0. That is really a generational high, and one would have to go back to the dot-com era at the turn of the century to find a broad market P/E that was so elevated.
So, how did we get so elevated? Second quarter earnings were much, much stronger than expectations. A full 84% of companies beat expectations, which, according to FactSet data, was the highest percentage recorded in this economic cycle.
Money is free. The New York Fed's official Overnight Lending Rate stood at 0.08% Thursday, a level it has held since "plunging" from 0.09% on Aug. 17.
Going further out on the curve is even more enlightening. Bloomberg is showing a yield on the five-year U.S.Treasury note of 0.68% and a year on the 30-year U.S. Treasury bond of 1.41%. Bond market geeks would note that those rates have risen slightly now on the back of the jobs numbers, but, really, can anyone make the argument that paying an interest rate of under 0.8% for five years is not free money?
It is free money, and thus any kind of leveraged play -- buying U.S. stocks and call options with borrowed money, for instance -- is much more economically feasible than it has been for the past 10 years.
This market values liquidity above all. Free money adds to the Jerome Powell/Steven Mnuchin flamethrower of Fed dollars that are buying government bonds, mortgage bonds and even corporate bonds issued by individual companies.
So, in the short run, a tidal wave of liquidity can offset worsening corporate earnings. FactSet's consensus for S&P 500 earnings for 2020 now sits at $132.11, a 19% decline from 2019's reported figure of $163.02. That offset drove the robust U.S. equity market action in August.
What will we see in October and then in the U.S. Presidential election in November? As the Beastie Boys once said, "my crystal ball ain't so crystal clear."
But here's a hint. Build and maintain positions in companies that are generating free cash flow and using that largess to pay dividends and implement share buybacks. Companies that are raising money from public investors in this environment should be avoided. Even CFOs (should) know when their stocks are overvalued, and that's when finance textbooks indicate companies should do equity offerings.
So, that's the frustrating thing. The army of buffoons who Wall Street has foisted on us this time (I was one once; most of us only last one business cycle on the Street) are lumping together companies that are producing entirely different economic results because they are -- here come the buzzwords -- disruptive tech companies. Arrrrrgh! Make it stop.
Apple is building capital, pays a dividend and is buying back shares. I don't think it's worth more than the entire Russell 2000, a threshold it passed earlier this week, but I can see the appeal in the stock. Tesla, on the other hand, just announced a new capital raise, and will never pay a dividend, buy back stock, or make even a token return on the capital it deploys. It's the anti-Apple and my firm, Excelsior Capital Partners, took a bearish position when the valuation reached an extraordinary $460 billion.
That trade is working so far, but they don't always. A great client from my sell-side days once told me "valuation is in the eye of the beholder." Own shares in companies that are actually creating economic value and you can let that valuation take care of itself.