(Bloomberg) — First, it was inflation. Then came shaky tech earnings. Now, Russia. Slowly, then all of a sudden, forces are gathering that threaten to wring out the excesses that defined the post-pandemic era in markets.
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Within the span of a month, sentiment toward risky assets — which bordered on euphoric — has shifted dramatically. Speculative equities that went straight up for years have fallen back to earth, brought down by the prospect of higher interest rates. Russia’s invasion of Ukraine sparked fears of a global energy crisis and raised the specter of stagflation. It all adds up to a remarkable coda to a two-year run that saw financial assets of all kinds soar as the Federal Reserve’s pandemic response flooded the system with money.
The result: Gambler spirits have cooled, the Nasdaq has been flirting with a bear market, and trillions of dollars are being erased from global stocks.
On the way up, Wall Street’s old guard warned time and again that people would come to regret the prices they paid for everything from SPACs to meme stocks and crypto. With U.S. shares now down in five of the past eight weeks, they’re feeling vindicated, as tightening monetary policy and war endanger what has been the most dramatic episode of speculation since the dot-com bubble. Wherever you look, markets appear vulnerable.
“Zombie companies, non-earning companies, the ones that were getting rewarded for seemingly no reason — they are the ones that are suffering the most, and regardless of how much they’re suffering, they’re not going to go back to those levels,” said Liz Young, head of investment strategy at SoFi. “The sea change is that ‘Oh, we can’t pump liquidity into the system forever,’ and we shouldn’t.”
Nobody is saying the broader market is doomed. Dip buyers, emboldened by years of conditioning, came out in force the last two sessions, swooping in after the Nasdaq 100 Index nearly closed in a bear market. Still, it took weeks of damage to the major benchmarks before they surfaced this time, a departure from last year when a single day’s decline was almost always enough to coax out the bulls.
For those who rode even relatively safe stocks skyward, there’s a sense the safety net has been pulled. Surging commodities will worsen inflation, leaving central banks handcuffed, sworn to higher rates and in no mood for the spendthrift rescues of yesteryear. The U.S. economy may be growing, but investors have pushed many share prices so far beyond expected earnings that even a 20% plunge would fail to make them obvious bargains.
How extreme did pricing get? As recently as November, the Nasdaq 100 index was trading for almost six times the combined sales of its constituents, double the valuation of 18 months earlier and as high as any time in two decades. At 22 times annual earnings, S&P 500 companies were considered expensive at the start of 2020, before the Covid-19 crash hit. Within a year the ratio jumped to 32, nearly twice the historic level.
Outside of the major indexes, the picture has frequently been one of full-blown bloat. Among smaller companies tracked in the Russell 2000, 47 surged 10-fold or more from the pandemic bottom through the end of last year. In February 2021, 93% of the index’s members were trading above their 200-day moving averages — the highest percentage on record.
“You had such crowded positions and you could see it in a variety of markets,” said Sameer Samana, Wells Fargo Investment Institute senior global market strategist. “You could see it in equities, with tech and other speculative stocks. You could see it in crypto, you could even see it in smaller cap stocks. We had this rolling bull market in risk assets in the fourth quarter when we realized that omicron wasn’t going to be as big of an issue as we had thought.”
Even after rallying to end the week, the S&P 500 is still 8.6% below its all-time high set in January. Richly valued technology shares — the stock market’s pandemic darlings — are down more than 14% from their peak.
While the revaluation has been swift, speculative areas are not out of the woods — at least from a valuation perspective. The Nasdaq 100, which bounced in the aftermath of Russia’s invasion, fetches 32 times earnings, down from around 40 at several points last year, but still above its historical average.
Lofty valuations of the pandemic era may have seemed justifiable against a backdrop of rock-bottom rates and billions of dollars worth of stimulus from the Fed each month. With the central bank set to lift rates and end its massive bond-buying program in March, risk assets were already under pressure to start the year. Now, as Russia sends troops into Ukraine and the U.S. levies sanctions, volatility is soaring.
“With the amount of stimulus and liquidity in the system, valuations and expectations got silly,” said Dan Suzuki, Richard Bernstein Advisors’s deputy chief investment officer. “Now that liquidity is starting to tighten and growth is starting to slow, those trends have reversed.”
In isolation, any of the threats facing investors might be navigable. The Fed is tightening, but from very low levels that aren’t likely to impede growth. Russia faces sanctions, but outside of its role as oil supplier it makes up a vanishingly small part of the global economy. And valuations are still high, but no worse than last year when stocks were surging. Put together, however, they are sowing a sense of exhaustion among traders, sapping sentiment as investors struggle to find reasons to be bullish.
To be sure, reasons for optimism can still be found in corporate America, where analysts’ earnings estimates for S&P 500 have yet to budge from their solidly upward trajectory. That follows a reporting seasons in which 77% of the index’s members beat forecasts, according to data compiled by Bloomberg.
“Since 1990 (when our data on forward earnings estimates begins), corrections that last at least 35 trading days have never been this large without a downward revision in earnings,” Bespoke Investment Group strategists wrote in a report. “That suggests analyst optimism isn’t a contrarian sell indicator at all but good news for stocks relatively speaking.”
Still, RBA’s Suzuki sees the possibility of pain ahead for the poster-children of the pandemic rally: technology and growth stocks. Bets against them are accumulating: short interest as a percentage of shares outstanding on the Ark Innovation exchange-traded fund (ticker ARKK) are sitting at a record 12.7%, according to data from IHS Markit Ltd.
“The elevated valuations embedded two unrealistic expectations. First, they assumed that the growth of the past several years was sustainable for the foreseeable future. And second, that all these new and innovative companies could turn out to be winners,” Suzuki said. “We think there’s still a bubble in parts of the equity market, and that bubble still has a lot of air in it.”
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