Valuations in a Behavioral Finance World

by Justin Lowry, CIO, Global Beta Advisors


The world has changed in many ways since COVID-19 took it by storm in 2020, and Wall Street has certainly felt the effect.  Fiscal and monetary stimulus coupled with increased curiosity in the stock market due to the afforded time from better work flexibility, easier access to financial information, and cheaper trading costs has caused a phenomenon in the U.S. stock market not seen since the tech bubble of the late 1990s.  We have seen a new generation of investors bid up stocks well in excess of the company’s current fundamentals with the idea that these companies will be “world changing” in industries (some newly formed) that potentially have “exponential growth”.  Of course, more recently, we’ve also seen a more malicious approach by new investors, specifically from the “Reddit” group dubbed “Wall Street Bets”, with the apparent objective to sabotage the short positions of large hedge fund managers and reap the benefits by bleeding the wealth from those large hedge funds and into the pockets of the common person.  Certainly, it remains to be seen whether there are other, larger players involved in this raid against these hedge funds.  This is done by investors purchasing large “out-of-the-money” call options from a market maker on a stock that has a high level of short interest relative to its available shares outstanding (i.e.:  free float).  Of course, these market makers need to hedge the risk of selling a call option by purchasing the underlying stock (the further out of the money the option is, the higher their cost basis of the stock can be) because it otherwise comes with unlimited downside risk as they need to eventually deliver the stock of the call option to the investor on the other side.  Therefore, these market makers effectively bid up the stock, which begins to put pressure on the short positions of these large hedge funds, who are then faced with the decision to close their short positions or incur steep borrowing costs of the stock to continue to stay short, given the increased demand for these shares.  This becomes a snowball event that artificially bids up the stock.   This is commonly referred to as a “short squeeze”.  As everyone is painfully aware of by now, the poster child event of this behavior has been demonstrated in the recent trading activity in Game Stop (“GME”).  Heading into the month of January, GME had a short interest of 141% (Source:  Factset as of 12/31/20), which means that the number of shares that are short are 141% of the outstanding float.  To put this in context, as of 12/31/20, Amazon had a short interest of 0.6%.  These investors targeted GME and employed the above strategy to squeeze those that were so heavily short the stock into covering and bid the stock higher.  The result has been a 685% return for GME for the year, through 01/26/21.  It also saw trading volume, as of 01/26/21, that was 27.5 times it’s 3-year trialing average daily volume (Source:  Factset ‘ data measured between 01/26/18 through 01/26/21).

While each instance is completely independent from the other, the commonality is that these investments and trades are not necessarily done on a fundamental or even technical basis but instead are a reflection of investor behavior that has meaningfully impacted price discovery in the stock market.  The question becomes, how do valuations make their way into a stock market that is loaded with endless liquidity and where investment decisions are being made on perception instead of reality?  Well, to help answer that, we look back in history for clues.  As goes the adage:  history tends to repeat itself.  Although that is cliché; sayings become clichés because they are true (even this statement!).

Tech Bubble
During the tech bubble that, for arguments sake, spanned between the beginning of 1995 until March 2001; we can see similar parallels that existed between then and now:

AOL and Yahoo Chat Rooms:
Although it seems impossible to think of a time where Facebook, Twitter, Reddit, and all other social media outlets didn’t exist; there was a time where the public communicated by phone (landlines, to be exact).  However, as the 1990s rolled on, the evolution of computers and technology took hold and the presence of chatrooms were introduced.  You had platforms, such as Yahoo and AOL (who?), that allowed free forum communication among the public.  It enabled anyone who had access to a computer and a telephone line to port their way into a virtual reality of communication.  However, this form of communication was the first of its kind:  an area of communication that harbored anonymity.  Anybody from anywhere under any pseudonym could log onto the platform and generate any topic they wanted.  Their topic didn’t need to be verified (sound familiar?), and as you can imagine, it created interesting dialogue (in some cases, hostile – again, sound familiar?).   One of the topics that consumed the threads in these chatrooms was investing, which was essentially the equivalent of what’s going on with Reddit today.  Similar to then, we have valuations that are well in excess of their historical averages and a stock market that is being led by a narrow group of technology stocks, along with a plethora of highly sought-after IPOs (Initial Public Offerings) and SPACs (Special Purpose Acquisitions Companies).  During the 90s tech bubble, a poster child for its hot IPO market was CMGI, Inc.  CMGI’s business model was quite genius, particularly for its time.  It developed e-commerce platforms to help software companies distribute their products.  However, unlike Jeff Bezos and Amazon, CMGI’s management team made the wrong investments to build out its business, and ultimately, fell under the weight of failed acquisitions in internet companies that were far overvalued and to which the synergies did not exist as expected with the company.  A company that returned investors 940% (Data from Factset) in 1999 then went on to lose roughly 95% of its total value the following year (Data from Factset from 12/31/99 through 12/31/00).  As CMGI has demonstrated, a stock with that kind of overexuberant momentum can fall under the weight of that momentum if it cannot justify its valuation.  It’s market experiences like this that have many experienced managers recognizing our current market environment as a bubble.  However, with the liquidity that has recently been provided by the Federal Reserve, the bubble has been far more persistent to this point.

Market bubbles and their effects are not just observed in the form of one stock.  Entire segments of the market can form bubbles, and it usually occurs when you see a single stock phenomenon, such as CMGI or Gamestop.  Of course, those two examples saw astronomic returns in short periods for different reasons, but they both were fueled by a common theme:  valuation was not going to determine how investors felt about those stocks, and that is something that we believe may be materializing now.   In fact, in 1999, the S&P 500 Index’s price to sales ratio was trading at a 27.12% premium to its 3-year trailing average (Data from Factset, as of 12/31/99).  Now, it is trading at a 27.08% premium to its current 3-year average (Data from Factset, as of 12/31/99.   What makes each extraordinary (and very similar) premium even more breath taking is the fact that they were/are driven by a small pocket of the overall market.  When you look at the attribution of the S&P 500 for the year of 1999 versus the year of 2020, it is quite remarkable to see the impact that the top 5 contributors had in the index at each point in time to the overall performance of the index.  As a reminder, many indexes (such as the S&P 500) weight their securities by market capitalization, therefore, the more the stock rises, the greater its composition in the index.  This can be a snowball effect that continues to feed itself as momentum persists in the market.  Below is a snapshot of the S&P 500’s attribution each point in time:

Dec 31, 1998 to Dec 31, 1999

S&P 500
TickerAverage WeightContribution to Return
Total11.938.39
MSFTMicrosoft Corporation4.062.34
CSCOCisco Systems, Inc.1.891.87
GEGeneral Electric Company3.461.77
WMTWalmart Inc.1.981.31
ORCLOracle Corporation0.551.10
S&P 500 Total Return21.04
% of S&P 500 Return by Top 5 Securities39.89

Source: Factset

Dec 31, 2019 to Dec 31, 2020

S&P 500
TickerAverage WeightContribution to Return
Total18.4511.51
AAPLApple Inc.5.784.13
AMZNAmazon.com Inc.4.193.09
MSFTMicrosoft5.492.59
NVDANVIDIA Corporation0.900.89
FBFacebook, Inc. Class A2.100.82
S&P 500 Total Return18.40
% of S&P 500 Return by Top 5 Securities62.56%

Source: Factset

As you can see from above, the S&P 500 had over 10% of its index occupied by 5 stocks in each time period (nearly 20% during 2020), but even more revealing is that the performance of those 5 stocks for each year was roughly 40% and 60%, respectively, of the index’s overall performance.  History has shown, as demonstrated in the above charts, that market bubbles usually form when narrow segments of the markets begin to drive the overall performance of an index, which was evident during the tech bubble of the 1990s and the subsequent market correction (Source:  data from FactSet as measured from 12/30/94 through 03/31/01).

What does it mean when the broad index becomes this overheated?  Well, below is a contrast of the S&P 500’s forward-looking return when it’s price-to-sales ratio is above and below 2:

S&P 500 Index Forward Returns When P/S ❯ 2

 

1-Year Forward Return5-Year Forward Return10-Year Forward Return
5.52%1.26%1.77%

Source: Factset; data measured from 03/31/95 through 12/31/20

S&P 500 Index Forward Returns When P/S ❮ 2

 

1-Year Forward Return5-Year Forward Return10-Year Forward Return
11.94%9.78%13.80%

Source: Factset; data measured from 03/31/95 through 12/31/20

As you can see, the prospects of its forward return outlook in the short, medium, and long term become substantially diminished when the S&P 500 is trading at a higher multiple.  Of course, this may seem like common sense, but it’s often lost in times of euphoria and momentum, which may seem everlasting but is ordinarily not and the pain of its reversion can be severe.

The bottom line is that investors need to carefully consider what they are buying.  The “hot stock tip” from a reddit user or even a friend should be taken with a grain of salt.  It’s always important to complete due diligence on an investment and understand its valuations, financials, and growth prospects.  There can even be substantial risks embedded in fund strategies that investors may not be aware of, which makes completing due diligence across all investments to be important.  It is important to understand your exposure regardless of your investment vehicle.  The hot performing security or fund may not have staying power and could pose a risk to your overall portfolio.