5 signs that point towards a stock market fall.
Introduction
At the start of September, I received a fair number of cautionary emails about the upcoming quadruple witching on 2020 Sep 18th. On these days, which happens 4 times a year, stock index futures, stock index options, stock options contracts, and single stock futures all expire. That was when SoftBank was unmasked as “Nasdaq whale” and Nasdaq Composite declined from more than 12,000 to just a tad under 11,000. The warning back then was that as stock price decline, option writers who had previously bought stocks to hedge the call options they wrote would unwind stocks. Meanwhile, option writers who had sold puts will need to keep selling stocks as market price near their puts’ strike price. Long story short: there will be intense selling pressure from all sides.
I looked at the chart for VIX and noticed the northwards march in VIX during 2020 March took place over 4 weeks. I concluded that on balance, given the amount of time left till September 18th, it would be unlikely that VIX repeats the same march. Sure enough, September 18th came and went, and Nasdaq stayed at a similar level as that in early September.
However, I observed over the past few weeks 5 signs that the stock market is headed for a fall.
Private Equity managers dividend recapitalizations
On 2020 Sep 17th, the Financial Times reported that
“So far in September, almost 24 per cent of money raised in the US loan market has been used to fund dividends to private equity owners, up from an average of less than 4 per cent over the past two years.”
Financial Times, 2020 Sep 17th: Private equity owners pile on leverage to pay themselves dividends
In a dividend recapitalization exercise, what typically happens is:
- A non-financial company that runs a real-life business operation takes out a loan from banks or other lenders;
- The operational company pays its private equity owners a dividend from the funds it borrows;
- The operational company books the loan as a liability in its balance sheet, and remains on the hook for the entire amount of the loan.
The advantages to the private equity owner are obvious. It gets a pay-back on its investment early. This improves its Internal Rate of Return (IRR), a widely used but flawed performance measure for the private equity industry. In an environment where bankers compete for fees, it is also likely that loan covenants remain loose. This means that private equity owners do not need to act as guarantors for the loans taken up by the operational companies.
Lenders also gain from such transactions. Not least of all is the fees and interest income these generate. Individual bankers closing the deals can also be assured of job security and bonus.
The suckers in the transaction are the employees of the operational company. In a climate when GDP is contracting the world over, the company can expect to generate less revenue. Out of this reduced revenue, the company needs to pay more to banks and lenders in the form of interest payments. That means less money to pay salaries, rent and other suppliers.
The net effect is that scarce financial resources are reallocated to those who already have plenty. This is the Matthew Effect in full force. The reduced financial resources of the operational companies would mean we should expect further pay cuts or even retrenchment for their employees. This will likely feed into a further reduction in GDP. It does not seem to me that this has been priced into the market.
SPAC parties
The second of 5 signs of a stock market fall is SPAC parties. SPACs, or Special Purpose Acquisition Companies, are also called blank-check companies. SPAC founders form the company and go out and raise a few hundred million dollars through an IPO, with the intent of buying another company with the money they have raised.
On 2020 Sep 16th, Market Watch ran a story titled: “2020 is the year of the SPAC”. The tagline says it all:
A record 82 special purpose acquisition corporations went public this year to raise a record $31 billion and more are on the way.
On 2020 Sep 17th, the Financial Times ran another story on “Why Asia is joining the global SPAC odyssey“. The reasons the author gave for the ascent of this asset class are:
The drivers of the SPAC surge in the region are basically the same as on Wall Street: low interest rates and markets awash in central bank-bestowed liquidity, which has given rise to a desperate search for yield among investors.
The key takeaway from the story, however, is this:
… many founders see SPACs as the solution to their dreams of achieving an exit.
To me, the signal that the SPAC parties sent is less of the entrepreneurial endeavours of its founders. Rather, the real informational content is the intention of existing business owners to exit. In particular, I would be attentive to SPACs intending to acquire businesses somehow related to the respective SPAC’s sponsors. Lawyers and even regulators would wordsmith around such conflicts. Investors should beware.
Snowflake IPO
The cloud software company Snowflake IPO-ed at a price of US$120 per share. It started trading on 2020 Sep 15th. Before 1 pm that same day, the share price had risen to US$245 per share, up 105% on the IPO price.
The most noteworthy investor in this IPO is probably Warren Buffett. Berkshire Hathaway’s total stake prior to IPO stood at $735 million. By the end of the week, that was worth US$1.56b.
I see two potential signals from the Snowflake IPO. Either
- The pre-IPO shareholders really wanted an exit, badly. They were so desperate they were willing to sell at 50% discount what the market would bear; or
- The post-IPO traders really wanted to buy, big-time. They were so desperate they were willing to buy at double the price what the original owners wanted.
I’m less convinced about the desperation of the post-IPO buyers. Snowflake’s share price during the week largely mirrored that of the other major tech stocks of FAANG. That indicates to me they were no more desperate to buy Snowflake’s shares than to buy any FAANG shares.
That leaves the desperation of the sellers. One might argue they have been misled by the IPO bankers. Nevertheless, we now know the insiders in the know expressed less confidence in the financials of the business than the outsiders.
And this is the common theme I see across the three observations above. In the dividend recapitalization by PE managers, the SPAC parties and the Snowflake IPO, I see the urgency at which existing owners want to cash out. These are the people who know their operations best: how much cash flow is the business generating, what the order book looks like. In the midst of QE to Infinity, when liquidity is widely expected to lead to asset price inflation, the insiders still choose cash over real assets. To me, this is the ultimate insider trade. And this time, they scream “SELL”.
Value versus Growth gap
The fourth of 5 signs of a stock market fall is the eerie similarity of the current growth-value gap and that during the dot-com era. I had previously written about the yawning gap between growth and value stocks. I traced the trajectories Vanguard Russell 1000 Value ETF (VONV) and Vanguard Russell 1000 Growth ETF (VONG) back to 2011.
This week, The Economist ran an article citing the same Russell 1000 index. The chart they ran has a similar gap starting from 2011. Even better, they ran numbers back to before 1996. This gave a good perspective of the trajectories prior to the first dot-com boom. From 1995 to 2000, the gap of growth over value stocks looked remarkably similar to the one from 2011 till now. The only difference is in the length of time. During Dot.Com.1, the gap widened over 5 years and closed rapidly from 2000 to 2001. In the current episode, the gap has been widening for the past 9 years and shows no sign of closing.
Yet, the Dot.Com.1 experience showed us that all good things come to an end. If reflexivity explains the bidding up of growth stocks valuation over the past 9 years, it could also trigger the reverse process. The urgency of existing business owners to cash out, as observed above, might just be the ball to set this reverse process going.
Productivity boom and bust
We will not have the full knowledge that existing business owners know about their companies. However, thanks to NBER, we know that the ICT-led productivity boom in the US had petered off. In fact, in the US, total-factor productivity and labour productivity for the 2005-2015 period had slumped below that for 1977-1995. The productivity story is even more dismal in European Union countries.
We might yet see another productivity boom with the accelerated deployment of new technology during the pandemic. What I have less confidence in is how wide a segment of the general population would benefit. The unemployment rate is still at decades high in many countries. The ongoing health repercussions of the COVID19 on the infected could lead to a prolonged period of declined productivity and consumption.
Conclusion
Despite numerous warnings, the quardruple witching that came and went this past Friday did not cause much upheavals. More concerning are the 5 signs of a stock market fall. These show that existing shareholders and business owners are keen to cash out. Some are even willing to do so at discount prices. The gap between growth and value stocks looks spookily familiar. Evidence of the ebbing of an ICT-led productivity boom also casts doubt on how the economy at large really benefits from technology.
5 signs of a stock market fall
