09 Jun Artificial Intelligence. The industrial revolution underway
The “equity bubble”. Reality or new evaluation criteria?
We live in a world that has been creating artificial money since 2010, and where this speed of money creation has accelerated due to the pandemic. At the same time, in a world still in recovery, we see that equity values, the so-called equity, does not stop rising, accepting that a gigantic bubble is probably being created, as big or bigger than that of credit. But is it possible that this is not so? Is it possible that excess money creation has changed the calculation criteria?
By Miguel Ángel Temprano
CEO Orfeo Capital
10th of June 2021
Reading Time: 4,50 min
I can imagine the disbelief of many small investors at what is happening in the equity markets, which go up and up like there is no end. The explanation that we all give is that equity has remained the only invertible asset in the face of a clear credit bubble with an upcoming expiration date.
“The new consumption habits have mistreated not only the income statements of many companies but also their valuations”
The more than probable changes in life habits generated by the pandemic that affect companies, where many live a parallel reality in a market, sometimes as overvalued as real estate or where raw materials are overvalued in a world where the use Real gold has been practically relegated to jewelry and where those raw materials now more valuable, the rare earths are mostly in government hands such as the Chinese and finally where the private equity market is still bleeding from the dent that the confinements have caused in the SMEs where they invest, leave equity as an asset as a refuge for an expected return.
“It seems incredible that the risk asset par excellence has remained the only invertible asset”
But we are not left alone here, we sweeten the previous explanation with that currently and “thanks” to the quantitative expansion that we are experiencing, obtaining money from banks is “free”, while having it in the freezer of a checking account will cost us from around 0.5%.
So the million dollar question is: is there or isn’t there a bubble in equity, or as it is called around these parts, in equities? Well, after thinking about it for a long time, I must tell you that I’m not sure. I speak with the frankness that I always speak and I am going to explain the reasons, not for the frankness but for the doubts and probably after reading the following those who think in one way or another will no longer be so sure that they are right .
“Why do we give the same value to money when valuing assets, if, since it is a scarce good, its value is influenced by the amount of it in circulation?”
Some time ago our director of operations put on the table a thought that since then has brought me down the path of bitterness. “If money is a scarce good and therefore its value, among other things, depends on the amount of mass in circulation, why do we continue to give it the same value, when valuing assets, as when this mass in circulation was less? ”
The value of money is implicitly included in the PER. “If it costs me less to get the money, I will be willing to pay more than before for an asset that gives the same results.” You will agree with me that as a theoretical doubt it is very reasonable.
“If asset discount rates are no longer stable, we enter a vicious circle of an equation where there are only unknowns (rate and benefits)”
But before this thesis two questions arise. The elementary: then at what rate should I discount it now? And the second: if we have been creating a massive money supply since 2011, why until 2019 were the PER multipliers more or less stable?
This last question could stand alone to thwart the thesis, but then why are markets going up and up? Why is a company like Adidas, which has had to receive a mega loan from the German government, now worth more than 20% more than before the pandemic? The cash flows discounted at the same rate as before minus the new debt, it should give me a lower value or at most the same, but no, it is much higher. Or is it that now everyone is going to wear sneakers all the time and Adidas is going to sell twice as much?
If you realize it, I do not have a clear answer to the why of the current situation, but I am much more inclined towards the theory of our director of operations, especially because it is an analytical theory.
But then what is the proper multiplier in this situation? The simple answer would be that money has lost value in the same proportion that the money supply has grown over inflation. But if we are as simple as this, we would come to the conclusion that the multipliers in Europe and the USA should be multiplied by two or even three, which per se is irrational, and very far from the current situation.
So we come to a malevolent conclusion, we cannot efficiently calculate the value of companies. And if you don’t look at JP Morgan or Goldman Sachs, let them make exaggerated valuation errors, unbecoming of the invaluable professionals who work there.
“We have lost the faculty of fine calculation, at least until the market stabilizes or a mathematician and future Nobel Prize winner recalculates the profit multiplier based on the excess money in circulation”
So we don’t invest? Do we play dice where to invest? Much less to both questions, we simply look for alternative methods in times of moving, as valid as the others, although it may not seem like it.
Without going into a theory of asset valuation and to be simple, we must look at some qualitative data that we like to value so little, and get out of the spreadsheet where many of us live to focus on looking at what happens around us, and said incidentally, which should be the first thing we always do.
Humanity, but fundamentally the one with the money, has literally lived locked up for a year. This closure has generated a quantitative monetary amount, quantified only in the USA, at 1.7 trillion USD (roughly almost twice the annual wealth generation of the 14th world economic power, Spain) and another qualitative value: a desperate desire to get out and spend it.
“There are two types of spending, the one that produces physical well-being and the one that produces emotional well-being”
I like to say that there are two types of expenditure, the one that produces well-being to the body and the one that produces it to the mind. And so you can see the difference, the first is what we do by going to the supermarket to buy food to feed ourselves and the second, which performs the same vital function as the first, is what we do in a restaurant because we like to enjoy company , the environment or simply not making the food. Well, those 1.7 billion, just from the Americans, is going to go to this second guy.
If we add this analysis to the fact that many companies due to their lack of activity have dropped their valuation by more than 80%, the equation comes out perfectly.
We might think that this is already discounted in the valuation of all companies, but if we accept the previous assertion that the multiplier of the PER now has to be another, and that despite the fact that we use to value the estimated results, in some cases of the 2023, there is no doubt that we must not look for the value in the default of the quotation but in the ability to capture that expenditure that produces well-being, because they will not be 1.7 B, they will be much more.
“If we accept the theory that excess money changes the profit multiplier to calculate the price of the security, nothing is expensive, or at least we do not know” strong>
To finish and as always we give an investment idea. In this case the cruise industry. And this because its narrowness, only three large companies are listed, now this apparent weakness is an opportunity for the investor and because its main barrier to growth, which is the number of available tickets, now plays in its favor, because reservations are going to be anticipated and the visibility of the business in the medium and long term will be much better.
These companies have recovered a great deal, but they are still a long way from their pre-pandemic valuations. And if there is a place that people with money can assure viral asepsis, it is the ship. Most of the companies require that the entire passage be fully vaccinated and when they disembark on an excursion they move in “bubbles” with which the chances of reinfection are very low.
Therefore an “infection” is highly unlikely and therefore its potential reputational damage is limited. The investment benefit seems assured.