The idea that we are in a market bubble is repeated constantly. Both public and private tech companies (especially) have been raising money at incredible valuations. Experts like Jeremy Grantham have explained in detail what he believes will become known as “one of the great bubbles of financial history.” Contrastingly, there are a few simple and interesting ways to show that in fact we may not be in such a bubble at all.
Firstly, we can look at markets relative to global liquidity. Of course, traditional valuation heuristics such as price to sales or earnings ratios suggest US stocks are more overvalued than in recent bubble periods of the late 1990s and pre-Financial Crisis. However, stocks exist relative to other asset classes, and layering in a liquidity factor suggests they may not be so overextended such that they ultimately must burst to correct.
Michael Howell of Crossborder Capital argues that markets are characterised by a dominant financial cycle at a macro level, “driven by shifts in liquidity and in investors’ risk appetite.” Clearly, prices are quite stable relative to Howell’s measure of global liquidity.
Another argument has been made by Packy McCormick, author of the Not Boring investment blog. He points out that the companies leading the tech charge – Facebook, Apple, Amazon, Microsoft and Google (FAAMG) – are in fact very reasonably valued on the same traditional relative heuristic bases being quoted for the stock market. He argues that while tech company P/E and P/S ratios are at uselessly high levels, emerging tech companies are being at least subconsciously valued relative to FAAMG, or the leader in each business vertical.
Understanding that these tech megacaps have proven they will continue to expand at unprecedented rates for companies of their size, FAAMG have become the de facto market ceiling. Hence, the ceiling represented by the market caps of the largest companies has grown 5-15x over the last decade. Each has a strong case to argue that they will be at least as valuable over the next decade.
Therefore, we can look at emerging tech companies’ valuations as the probability they will be as large as FAAMG, or the biggest company in their vertical. Packy uses Shopify relative to Amazon as the textbook example here. Shopify has appeared overpriced since its IPO in 2015, growing over 40x, yet investors continue to pay more for the stock. However, stating Shopify’s $140 billion market cap as an 11% probability that it can be as big as $1.6 trillion Amazon today might be easier to reason than a 300x forward P/E.
Naturally, this argument also highlights where sectors can appear truly dislodged from reality. Electric vehicle companies seem to emerge every week with near-zero revenues and billions of dollars in market cap. They are tied to a more speculative Tesla, which may ultimately grow into its lofty valuation but still has plenty to prove.
Coupling the abundance of liquidity with the expansive (and reasonable) market ceilings of US tech megacaps suggests that the stock market may even have room to grow. A bubble implies overextension needing to burst in order to return to historical normalcy; however, it feels as though we would need to spread the vast injections of global liquidity very thin before we reach that kind of trouble.
Lachlan Mackay is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.