January 28 2021

Do Trees Grow to The Sky?

Spoiler alert: No, they don’t. The pernicious effect of very low rates makes equity premium more attractive, hence naturally pushing equity allocation higher. More buyers mean higher stock prices, which drives the expectations of future returns to stratospheric highs.

US Tech companies trade at a Price-to-Earnings ratio of 45x. It is fine when you consider that some of them could develop exponentially their sales and margins by making forays in new businesses. Some others, like Apple, are already gigantic $300bn businesses growing at an average rate of 4% and a stable margin over the past 5 years. Albeit they demonstrated a great knack for innovation, you could argue that pricing their shares at 45 years worth of earnings is a bit much. Depressed rates have for side effect of discounting a bigger chunk of future growth.

The Federal Reserve introduced great complacency and a hunt for yield by making debt and deficits not matter anymore. Market is over-heated by insatiable greed, best exemplified by the surge in options volume on US exchanges, doubling to 40m daily in the first 3 weeks of the year. More precisely, call options are outnumbering any other by far.

Call options are rights with no obligations, and such a great parable to explain the mindset of a growing crowd of day-traders. And also, a sign of times when the world expects to breath a sigh of relief after so many obligations and privations of the covid era. Rights only is what people desire.

In such environment, the only investment playbook that’s left is momentum. As an investor, you get carried away by the powerful hand of the market. However, like trees don’t grow to the sky no matter how much water you pour in, there will come a time when debts will have to be paid out. Whether it is through taxes, or higher inflation, you will have to pick your poison.

360 Advisory – Markets