An Unmistakable Sign of the Top
Editor's note: It's the bull market that won't die... at least not yet.
After bottoming in March 2009, the benchmark S&P 500 Index started an incredible run... It's up roughly 330% since then. And the Nasdaq Composite Index – which is full of high-growth, technology-focused stocks – is up around 515% in the same span.
But a few weeks ago, our colleague and Extreme Value editor Dan Ferris noticed a dramatic shift in the market... As a result, he believes everyday investors should be cautious today.
In the Masters Series this weekend, we're republishing two of Dan's recent Digests to make sure you fully understand what he believes will transpire in the months and years ahead.
Today's essay first appeared on September 3, before this shift occurred. In it, Dan looks at some of the warning signs he sees in the market... explains what really crushes folks in a bear market... and details why certain companies might soon need to face reality...
An Unmistakable Sign of the Top
A time to be skeptical, a time to identify risk...
I have quoted Ecclesiastes 3:1 to my Extreme Value subscribers before...
To every thing there is a season, and a time to every purpose under heaven.
There's a time to talk about cheap value stocks and great businesses selling at reasonable prices. There's a time to remind investors that buying low means holding your nose and plunging in when everyone else is selling...
There's a time to be an optimist, a buyer...
And there's a time to look back at the history of bear markets and crises and shout from the highest mountain peak about the many risks that investors face (like I did in recent episodes of the Stansberry Investor Hour podcast here, here, and here).
There's a time for caution, a time to be a skeptic.
Until the stock market gives up 30% or so from its all-time highs, I'll continue to be a skeptic and worry about risk. So let's get to worrying...
This is a classic late-cycle development...
In late August, the research gurus at Miami-based Leuthold Group published a cool series of charts – called "Portraits of a Split Market" – showing that investors have taken money out of smaller-cap, lower-quality, volatile stocks. These investors began putting their money into large, stable, higher-quality stocks starting in January 2018.
It makes sense... When investors get scared and want to prepare for the worst, they sell lower-quality businesses and buy higher-quality ones. In Extreme Value, I've recommended certain stocks in the past several months with that thought in mind.
And all that money fleeing smaller-cap stocks has created an opportunity for active investors, according to Mike Burry.
Burry runs the Cupertino, California-based Scion Asset Management investment firm. He made a fortune betting against mortgage-backed securities before the housing bubble blew up in 2008. If you read the book about the mortgage crisis, The Big Short, you probably recognize his name. If you saw the movie, Christian Bale played his character.
Here's what Burry says about the market today...
The bubble in passive investing through [exchange-traded funds] and index funds as well as the trend to very large size among asset managers has orphaned smaller value-type securities globally.
He recently disclosed stakes in brick-and-mortar gaming retailer GameStop (GME) and clothing retailer Tailored Brands (TLRD).
Burry has more guts than me. I'm a value investor, but I can't stomach levered-up, beaten-down companies like GameStop and Tailored Brands.
I still believe we're about to enter a new 'Golden Age of Value'...
We're just not there yet.
I spoke about this with deep value investor Tobias Carlisle on a recent episode of the Stansberry Investor Hour.
Carlisle is like me... patiently waiting for the cycle to turn, as it always does, and once again make value strategies more attractive. But for now, he's willing to buy some value opportunities when and where he finds them.
I sometimes wonder if the next bear market could be much longer than anyone is anticipating. In Japan, the Nikkei 225 index peaked in 1989 and has never fully recovered. Today, it sits about 45% below its peak.
I worry that would hurt investors, even value investors like me. But Carlisle suggests it might not be so bad...
When I asked him what he thought about America's potential for a Japan-like long-term downside, he said that would be OK with him. That's because value investing has worked well in Japan during the last several years... even as it has pretty much gone out of style everywhere else, due to years of underperformance.
So if the U.S. economy goes into an extended funk, value investors are more likely to thrive in the coming years.
For now, I'll have to put up with articles like the recent one in the Toronto Globe and Mail newspaper titled, "Five Reasons Why Value Investing May Never Again Regain Its Appeal." At first, I thought it was some type of parody, but then I noticed that it's written by a guy selling growth stock picks.
A plethora of weird, unprofitable initial public offerings ('IPOs') is an unmistakable sign of the top, too...
Most are either technology companies that make no money, or companies that want to pretend they're technology companies that make no money.
Either way, making money at this point is a sign that you're not really serious. Remember the gross-out TV show Fear Factor, where guests were challenged do crazy things like climb into a box full of snakes or eat live, giant cockroaches?
That's where we are now in the market: It's the "Fear Factor IPO" market, where investors have to buy into crazy new stocks. Those who require profits are labeled cowards.
Exercise-equipment maker Peloton smells like a typical Fear Factor IPO...
The company sells $2,000 exercise bikes with TV screens attached.
The TV sets are special because – for only $39 a month – you get to watch somebody you don't know pedaling an identical machine. The person on the screen is an instructor who tells you what to do. He tells you how fast to pedal and shouts stuff like, "Good work!"... even if you're just sitting there eating potato chips.
But it's good the person is there. How else would you know when to stop pedaling if you happened to figure out how to work the thing on your own? The $39 a month is obviously money well spent.
Peloton draws you in with its TV commercials featuring good-looking, fit, young people pedaling a stationary bike to beat the band, sweating like crazy, and watching the TV set with the person on the screen telling them how to pedal.
Peloton is no one-trick pony, either. It also created another product: a $4,000-plus treadmill.
Peloton's treadmills are expensive because – you guessed it – they have large TVs attached, and how would you know how to walk and run without the TV, the $39-a-month subscription, and the person on the screen?
If I've left you with the impression that Peloton is merely a company that sells exercise equipment with TV screens that require a $39-a-month subscription, I apologize...
Peloton is way more than that. The company's recent IPO filing contains a letter from CEO John Foley to prospective investors, which begins...
It is no secret that exercise makes us feel good. It's simple science: exercising creates endorphins and endorphins make us happy. On the most basic level, Peloton sells happiness.
I assume Foley wrote and published those words with a straight face. But it's a weird way to start a letter to prospective investors. And that's just part of Peloton's weirdness... In a CNBC interview recently, Foley proclaimed Peloton is "weirdly profitable."
I think he was trying to say that Peloton is on the cusp of making a profit, and that's weird because profitability isn't really a feature of the IPO landscape these days. But really, it is anybody's guess what he meant, given the following lines from the first item under "Risk Factors" in Peloton's IPO filing (emphasis added)...
We have incurred operating losses in the past, expect to incur operating losses in the future, and may not achieve or maintain profitability in the future.
We have incurred operating losses each year since our inception in 2012, including net losses of $71.1 million, $47.9 million, and $195.6 million for fiscal 2017, 2018, and 2019, respectively, and expect to continue to incur net losses for the foreseeable future.
Peloton's revenue was $218 million three years ago and $915 million last year... yet losses are growing, not shrinking.
Maybe he's talking about the company's 42% gross profit, which is larger than Apple's (AAPL) most recent quarterly gross profit, at around 37%. Of course, Apple had an 18.5% net profit margin, after all expenses and taxes. Peloton lost about $200 million... and it doesn't expect to make a net profit anytime soon.
Peloton strikes me as the Tesla (TSLA) of exercise equipment: There's more cachet than genuine benefit to owning one. And yet, I bet showing off your stationary bike won't feel nearly as good as flashing a Rolex, an Apple Watch, a Tiffany bracelet, or a fancy electric car.
To hear Peloton tell it, it's not the Tesla of exercise equipment. It's the Amazon (AMZN), Apple, FedEx (FDX), Facebook (FB), and much more... I'm not kidding. Its IPO contained the following slide...
I think people in the psychology world call this multiple personality disorder or something like that. Anyway, they treat it like a disease.
(You can check out Peloton's IPO filing right here.)
I can't imagine Peloton will exist five years from now. It does nothing that can't be imitated by larger, better-financed competitors. I don't wish the company ill, but I wouldn't touch the stock (on the long side, at least) or buy the product.
Peloton and other recent IPOs are typical of our era – unprofitable, early-stage companies...
They're able to go public mostly on the promise they'll continue to grow revenue at a torrid pace, eventually eclipsing their substantial expenses, resulting in profitability. (Peloton revenues have grown fourfold over the last three years.)
They're nothing like the "FAANG" stocks: Facebook, Apple, Amazon, Netflix (NFLX), and Google parent Alphabet (GOOGL). Those cash-gushing mega-caps dominate their markets...
Facebook owns most of the social media market (including Instagram). Google owns the global search market. Facebook and Google have dominated online advertising. Apple shares the smartphone and tablet device markets with Samsung (but earns more than 70% of the profits). Netflix owns streaming (for now). Amazon owns online retail.
Australian money-management firm Aoris Investment Management doubts the FAANGs' dominance will last...
It recently published a report called "FAANGs: The sun has set on their days of dominance." The firm argues that these companies have entered an era characterized increasingly by maturing markets and rapidly rising competition.
And the competition no longer comes from small upstarts. They've swatted them away. Now it comes from smarter, bigger competitors... often another FAANG peer.
The Aoris report details the FAANGs' rising cost of maintaining dominance in their current core markets.
For example, Netflix created the market for online streaming of movies and TV. A year ago, a report from bandwidth management company Sandvine showed that the streaming giant accounted for an astonishing 15% of all Internet traffic. And it will spend $15 billion on original content this year, roughly seven times what HBO spends. Netflix will spend another $3 billion on marketing, more than HBO will spend on programming.
Despite billions spent on original programming, 72% of Netflix's content is created by other studios. The six most popular shows on Netflix are all non-Netflix productions (The Office, Friends, Grey's Anatomy, NCIS, Criminal Minds, and Shameless).
By now you know Disney (DIS), WarnerMedia (HBO's parent), NBCUniversal, and CBS (CBS) are all launching their own streaming services. Disney has already decided to pull all its content from Netflix. (Ouch!) The most popular show on Netflix, The Office, will move to NBCUniversal's streaming service in 2021.
Aoris lays out a similar scenario of maturing markets and new competition for Facebook...
Maintenance of the company's core ad market, plus new forays into streaming and online retail, have accompanied a 10-fold increase in capital spending over the past five years. Meanwhile, Facebook has already ceded the No. 2 spot in online retail ads to Amazon.
It's hard to believe a social media company will make meaningful headway against the big online streaming services or in the cryptocurrency market. (Facebook recently announced its own virtual currency, libra.)
I'll say it again...
Stock picking and asset allocation don't crush you in a bear market. A lack of imagination is what crushes you in a bear market...
Everybody thought Cisco Systems (CSCO) was the best business in the world in early 2000. It was in 10 of the top 10 mutual funds of the time. Pundits fell over themselves to praise its management, technology, and market dominance.
The company's stock peaked at $80 per share in March 2000 and bottomed out two years later south of $9 per share... a nearly 90% drop. Nobody could imagine it. They never saw it coming... the same way they can't imagine it happening to the FAANGs today.
None of this changes the cash-gushing profitability and market dominance of the FAANGs as a group today, but...
Even if the FAANGs aren't in big trouble, the market for capital – which has been extremely generous with the technology world the past few years – has begun demanding better financial performance than some of the big tech players can currently deliver. You can tell by all the convertible bond deals done over the past year by the likes of Snap (SNAP), Twitter (TWTR), Tesla, Square (SQ), Atlassian (TEAM), and Splunk (SPLK).
Companies issue convertible bonds so they can pay them back with stock instead of cash. Convertible bonds carry low interest rates and convert to equity at a higher stock price than at the time of issuance. The debt can be paid off with shares.
Convertible issuers are usually unable to borrow money at low rates, often due to a less than stellar financial condition. They issue convertibles in lieu of issuing higher-yielding "junk" bonds because they can't afford to get bogged down with big cash interest payments.
Convertible bond deals are easier to do than straight equity or debt offerings. They don't require a credit rating or a time-consuming, expensive road show (where the company pitches prospective investors in several locations). A convertible deal can be hammered out in a single day.
Recently, capital market information provider Dealogic reported that the 15 largest convertible bond deals so far this year raised $17.9 billion total, compared with the $16.5 billion raised by the 15 biggest deals in all of 2018. The company said tech companies have been active this year, accounting for an estimated 43% of 2019 deals to date.
If you can't borrow at low rates near the top of a global bond bubble that has pushed $1 trillion in corporate debt into negative-yielding territory, you may soon have to face the fact that you aren't running a very good business. Maybe not right away...
After all, the convertible deal you just did bought you some time. But soon... soon...
Good investing,
Dan Ferris
Editor's note: A huge market event occurred on September 9 – less than a week after we originally published Dan's Digest. As a result, if you've made any money at all during this historic bull market, you need to know... Every dollar of your profits is now on the line.
But it's not all bad news... As this shift plays out in the months and years ahead, a specific type of stocks is set to outperform. Even better, Dan has identified the top three stocks in that group. He just released a special presentation with all the details. Watch it right here.