When Expectations Meet Reality

When Expectations Meet Reality

The markets are starting to feel a bit like a runaway train, moving higher through July and August and starting September off on a few strong days of trading. The S&P 500 has breezed past 3,500 when back in April it seemed like that was out of the picture; the NASDAQ, backed by tech’s resilience and high-flying growth, already passed 12,000 and the Dow is inching towards 30,000.

However, some cracks are starting to form in the market. The momentum that has been carrying the rallies for the most part is extending over to other names who have yet to prove strong quarters, and even strong quarters are leading to selloffs due to the extreme momentum leading into earnings. Thursday’s sharp selloff is a prime example of some of these cracks starting to form after euphoric momentum pushed markets to new highs – the NASDAQ fell over 5.5%, while the S&P dropped 4% – almost like the beginning of the March selloff in terms of magnitude – although the indices recouped some losses going into the close.

But earnings aren’t just the only place where some disconnects can be seen. Value and growth stocks alike are rising way past justifiable multiples and valuations – while I do hear around from time to time that “valuations don’t mean anything in this market” – there is a time where valuations will have to start to matter, and where stocks will have to trade based on their fundamentals and appropriate valuations. It’s just getting stretched too far, and chasing a pretty penny after seeing a company triple in six months might just get you caught at the top.



So let’s start with a bit of the earnings momentum movements we’ve seen this week. This was kicked off by Zoom (ZM), no doubts about that, as it rose to a hardly sustainable valuation. Shares soared over 40% by the close on volume of 96 million – over $40 billion in dollar volume. But Zoom’s euphoric rise on Tuesday instilled massive rallies in other beneficiaries of the work-from-home dynamic. The biggest winners were DocuSign (DOCU) which rallied 20%, CrowdStrike (CRWD) which jumped 14%, PagerDuty (PD) 12%, Zscaler (ZS) 11% and MongoDB (MDB) 7%; however, other names were involved in the rally.

Wednesday afternoon’s earnings featured primarily tech companies: CrowdStrike, Cloudera (CLDR), eGain (EGAN), PagerDuty, Smartsheet (SMAR), and Zuora (ZUO) all ended in the red after-hours; MongoDB and Guidewire (GWRE) were the only two tech names to show gains after hours. It’s not that the rest of the tech posted poor quarters – it’s that the expectations of a good quarter had already been baked in the price and then some; the companies are getting punished for beating estimates and raising guidance.

So what do these all have in common? For one, all are tech-involved, and all posted beats in both earnings and revenues. And even for those who upped guidance, like Cloudera and CrowdStrike, shares couldn’t find a gain. What would typically see shares bounce higher is causing shares to tumble, as the tech industry roars higher. Expectations are simply rising too high and momentum carried along from ‘tech’ or ‘growth’ association and other companies’ rallies can’t even sustain great quarterly results.

Coming along with that is an extremely high level of euphoria in the markets – it’s running almost as high as the dot-com bubble before it popped. When earnings don’t align with the level of euphoria circulating those stocks beforehand, a great quarter can get unjustifiably punished.

Citi

Source: Bloomberg

What was once the fastest decline of the market evaporated in a matter of months and translated into the best August in 36 years – it’s almost boggling how such a rapid swing can happen when millions are facing evictions and going hungry, corporate profits in impacted sectors slumped, unemployment soared, to name a few. But the markets don’t reflect the economy – yet we’re still getting a bit too out-of-sync with the reality ahead.

Momentum is not a force to be reckoned with at the moment, with both tech and the broader indices rallying higher even if there seems like little fuel left in the tank. The retail investing environment has changed – social media is starting to move markets in micro-caps, Robinhood investors are flocking to the biggest momentum names, and high trading volumes are impacting brokerages and causing some outages. I wasn’t yet alive for the dot-com bubble, but some of you lived through it, so it’s likely that I see it differently; this ‘bubble’ isn’t quite the same.

Here we have a global pandemic. We have the Fed pouring trillions in stimulus into the economy. We still have economic recession indicators flashing, like those mentioned previously. We have more unknowns with a vaccine and with the duration of immunity. Yet we have a market riding higher on euphoria just like it did in 1999.

Stocks are meant to grow – at the end of the day, you want to invest in something that returns you much more than you paid – but when stocks rise and rise at the degree that they have risen recently, that’s when the disconnects occur.

Euphoria and extreme bullishness have arisen similar to the dot-com bubble because millions of investors are seeing tremendous profit-taking opportunities in hot tech names as well as recognizable momentum names like Tesla (TSLA) (and millions of call options profiting as well). When the money starts to flow, and the bandwagon starts rolling, more and more start to jump on – compounding the overall level of profits and euphoria. But there comes a time when the underlying fundamentals start to show their fangs.

At some point, companies like Tesla and Zoom capture so much momentum that they start to outpace any sort of possible growth in the future. Tesla’s powerful August rally came to a screeching halt to start the week, but there’s still a claim to be made that its valuation now will be hardly justifiable even further down the road.

There’s a balance that needs to be found between risk and reward when investing, and as euphoria and demand are driving momentum stocks and related names higher, the risk to purchase shares at outrageous valuations (I know, “valuations don’t matter”) might have already outpaced the reward. But that doesn’t get seen, that doesn’t get talked about. Paying these ultra-premium valuations just seems to go unnoticed.

Then again, it might just have to do with human nature. Emotions tend to get the best of us sometimes, it’s just how we’re wired. And aptly named is Citi’s (NYSE:C) index, between panic and euphoria. Once we start winning, it’s hard to knock off that ‘untouchable’ feeling and you’ll start to feel like you’ll always win – isn’t that how a casino makes their money? But once you start to lose a portion of those winnings after running on that high for so long, and it starts to get wider and wider, well, you might start to double-down in a frenzy to recoup it all. That’s where the panic sets in.

But investing isn’t so much a solo game like blackjack. Investing comes with the crowd. One individual’s panic is hardly enough to make a dent in a group of one thousand, but when one hundred start to panic, more start to take notice. Crowds tend to exert more influence over individual decision-making than due to the influence and hypnotic nature of the mass involved. It’s like Le Bon’s idea of contagion as one of the three stages of a crowd – everyone in the crowd starts to follow ideas and emotions without question.

Euphoria can be derived from this subset of crowd psychology. As the crowd begins to win and win big, everyone else in the crowd might start to assume that they can too, by simply following the actions of the crowd – is Tesla really worth $450 billion, or is the crowd ‘cult’ forever ignoring the impossible market share needed to grow from that valuation?

And back to Le Bon – once a crowd starts to reason, it becomes the ultimate destructive force. Individual euphoria and panic (as well as other emotions) are hidden by the crowd if they differ from the crowd, but once the crowd feels the overarching euphoria (as we see now), the untouchability and defiance of what seems justifiable disappears; once the crowd begins to realize as a whole what it has just created from its euphoria, and begins to panic, the downward spiral eviscerates the crowd.

And here’s where valuations start to matter – say, everyone wants a piece of an unknown pie that’s rumored to be out-of-this-world, but the pie is getting more expensive from demand and the crowd. And as the pie continues to get more expensive, slowly less and less people will be willing to pay for it. Is Apple (AAPL) really worth 36% more now in September than it was in July? Did revenue growth support that, or is it just pure multiple expansion due to momentum? Is Lululemon (LULU) really worth 51% more now than it was in February even as quarterly revenues are expected to be down again YoY, putting it at 13x forward sales?

The risk-reward balance has been skewed towards reward for the past few months, as enormous gains have been delivered. But risk can’t be forgotten. At stretched valuations, the risk to buying now is that these valuations aren’t simply stretched, but representation of multiple expansion, and future gains will come as earnings and revenues grow at these expanded multiples. Yet that can be very hard to justify sometimes. While in euphoric states, there’s little fear that buying something at such a lofty price or valuation will end poorly, as the focus is on the potential profits.

But that risk looms large, especially as companies like those tech names mentioned in the beginning are plunging even after posting strong quarters and raised guidance. Investors hope for more than they can get, and when they don’t get it, disappointment sets in as the momentum that was just there disappears. Yet in euphoria, that disappointment can be short-lived, as the crowd rules all, and optimism is quick to return.

At the end of the day, investing now in the momentum names, tech, or some of the highest returning companies/beneficiaries of the pandemic attracts hope for high rewards, but deep down hides a larger risk. There’s the risk that these companies aren’t just establishing a new expanded baseline of multiples, and are trading far above their true potential because of the euphoria and crowd psychology. ‘Untouchability’ and the feeling of always winning are still leading the pack, and panic like we had seen in March has been forgotten. A shift in single individuals might be hard to notice, but a shift in the crowd will cause a wave of emotions to rapidly change, and that dynamic could cause unexpectedly large swings in prices in both stocks and indices. It’s hard to say that this isn’t a bubble, but it’s just as hard to say that it is one yet, due to the power of the crowd. Yet expectations are slowly starting to look more disconnected from the reality, and the cracks and glimpses are starting to arise.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


Originally published on Seeking Alpha

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