Buy the dip or rotate?

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Buy the dip or rotate?

Everyone is buying the dip, because it’s a great opportunity. Or is it? Filipe R. Costa investigates…

It seems the growth factor is running out of steam after gathering pace one year ago. Tech stocks doubled their value in a year and the cryptocurrencies market has seen its market cap rise from $140 billion to $2.4 trillion. There’s too much money lying around, seeking out speculative opportunities. However, there are warning signs that indicate the end of the cycle could be close. Well, maybe not the end, but at least some exhaustion that suggests it’s time to rotate.

There’s not much to complain about when prices double from one year to another. However, the rise in prices is decelerating this year. The Nasdaq is still up year-to-date but has declined 6.4% since its peak at the end of April. Some heavy weights like Tesla and JD are down 20% year-to-date and the once high-flying microprocessor maker AMD is also down 16%. Some would say this is just the result of profit taking but I believe it’s more fundamental than that.

Central banks seem way behind the curve. By now, interest rates shouldn’t be near zero and there’s little to justify an asset purchase programme. Stock markets are near all-time highs. Why would a central bank be willing to pump such a market even higher?

If we look at all the money that has been thrown at the economy by governments, we end up with massive liquidity that has been directed, to a large extent, to financial markets, not consumption. While there are some indicators showing an increase in consumer inflation, I believe inflation is largely showing up in asset prices instead. The price-to-earnings ratio for the US market rose from 18.7x in March 2020 to 35.0x in March 2021. Even when using a better metric like the EV-to-EBIT ratio, most markets look way overvalued, with the exception of Japan, where the euphoria has been contained.

But there’s more to the asset price inflation theory. Just look at the massive rise of the cryptocurrency market. It is now 18x bigger than it was one year ago. I guess we know where the US government stimulus checks are going… 

I’m certain Cathie Wood, CEO of Ark Invest, doesn’t agree with me on valuations, as she expects Bitcoin will hit $500,000 and manages a few funds that are filled with growth companies. She would say these metrics rely on the past while projected earnings are huge.

However, relying too much on future earnings has two big problems. First of all, these are just projections instead of realised values. In the meantime, many things may happen and the price to pay for this expectation is currently big for the risk taken. Second, when you have a lot of earnings projected into the future, a small increase in discount rates leads to a significant cut to the present value of those future earnings.

Long-term bonds suffer from the same disease. As can be read in the latest FOMC minutes, some Fed officials want to begin discussing a plan for reducing the central bank’s bond buying programme at a future meeting. This is way more than what was suggested by Jay Powell in the recent past and indicates that Fed officials are concerned about inflation (and a potential market bubble). They are preparing the market for an interest rate hike to avoid a crash.

Given that many of the tech/growth stocks trade on gigantic price ratios (including Tesla) and that it’s just a matter of time until interest rates rise, I would say that these stocks are currently unattractive. More conservative sectors of the economy are gaining traction and will likely outperform technology. The Dow is currently outperforming the Nasdaq, as depicted in the chart below.

One important final point worth mentioning relates to the cryptocurrency market. On 19 May, the market crashed. Bitcoin was trading at $38,700 at 1pm and saw its price sink to $28,700 in less than an hour. That’s a $10,000 loss or 35% in relative terms. If you go deeper into the altcoin universe, most of them have lost more than 50% of their value in less than an hour.

This volatility certainly makes these crypto assets worthless as mediums of exchange (which should carry a very low volatility). But, more importantly, this volatility is a byproduct of the massive liquidity that central banks have made available. It’s fair to ask: Is the Fed preparing to include altcoins in its future asset purchase programmes? It should because it will need to.

For now, everyone is buying the dip, because it’s a great opportunity. Or is it? Personally, I the risk isn’t worth taking.


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