Juggling Dynamite

Historically, it is typical for the most widely held, over-valued stocks in a market cycle to have negative or zero returns for many years thereafter.  Today, the top five stocks in the S&P 500–Microsoft, Apple, Amazon, Alphabet (GOOGL), and Facebook–make up over 20% of the large-cap US index and 40% of the NASDAQ 100.

As shown below, this level of extreme valuation for the five largest companies surpasses even the fleeting tech-wreck top of March of 2000, whereafter a 78% decline in the tech sector helped the S&P 500 lose 50% of its value.

Since March 23, free-flowing funds from governments and central banks have driven a resurgence of animal spirits in market participants and the US stock market has led the world in a price bounce.  As shown in my partner Cory Venable’s chart below of the NASDAQ index from March 1999 to October 2000, very similar price action came after the first 41% drop from March to May 2000 as stocks staged the first of four 28 to 43% rebounds, during their 2.5 year mean-reversion journey back to reality.

As shown below, today it is once more the NASDAQ 100 (QQQ) index leading the bounce to reclaim a 5.24% gain year to date.  At the same time, other economically sensitive small and medium cap companies as well as emerging markets and Europe, Australasia, and the Middle East (EAFE) shown below remain moribund and deeply negative.  See First Liquidity, Then Solvency.

The biggest tech darlings are overloved and concentrated in most funds and portfolios today.  This is likely to hurt returns from here.  It was not until June 2015–more than 15 years later–that the NASDAQ 100 reclaimed its March 2000 peak.  By then, most of the original holders had long since liquidated in losses.  This time is unlikely to be different.

There is no sign that the 2020 bear market has ended yet.  Buy and holders beware.

In the last decade, the dominant corporate model has been about rewarding short-term extractive shareholders and lenders, at all costs, with the masses dependent on debt to make ends meet.  The price has been lost savings and productive investment along with deficits and shortfalls compounding for years into the future.

We don’t empower a nation by taking advantage of the young and vulnerable when they are looking for help to get started.  As I explained in Young and old debilitated by debt-dependent business model:

The answer is not more loans, and lower rates and more government subsidies to for-profit-corporations; the answer is more affordable, efficient programs and systems that cost less and enrich the masses with better health, education and self-sufficiency.

Ironically, it took a pandemic to provide the inevitable tipping point.  With an abrupt drop in income, keeping up debt-fueled appearances is no longer a possibility for many. Suddenly, there is a perfectly respectable reason to seek the services of an insolvency trustee, downsize, reduce spending and look for ways to share costs.

Two areas that have driven the bulk of household debt in Canada over the last decade have been soaring real estate and post-secondary education costs.  Both have now entered into a major reset period.

Evaporation in short-term vacation renters has left many property owners without the necessary cash flow to cover carrying costs at the same time that many long-term renters are falling behind too.  This will drive more to consolidate living arrangements while pushing excess supply onto the rental market, increasing properties for sale, and exerting downward pressure for both rents and prices. At the same time, as more people work from home, many no longer need to be living in the most expensive urban centres and migration to more affordable places makes sense.  See Condo vacancies rise, rents fall as pandemic crushes GTA’s short-term rental market. Commercial properties are over-concentrated in many previous hot spots too, see: BMO says 80% of employees may switch to blended home-office work.

At the same time, post-secondary schools are being forced to offer their programs online, with the prestigious Cambridge University, England being the latest to announce today that all of its lectures will be online until the summer of 2021.

As shown in the chart below, nearly half of the average annual post-secondary costs in Canada are student rent and travel to and from school.  With just a third of students having an education fund (RESP) to draw on, funding depends on help from parents, student jobs and increasing debt for both the parents and the students.

With fewer people working and most already indebted, an obvious solution is for students to live at home wherever possible.  Online studies make this more feasible than ever. Immigrant families have long benefited by the multi-generational efficiencies of shared living arrangements, other families will do so too.

At the same time, there is an expectation that online education should be less expensive than the on-campus experience, and schools will be pressured to reduce the price of their services.

Shelter and education costs, two of the largest drivers of household debt, are coming down.  This is part of a much-needed increase in productivity, reduction in debt, higher free cash flow, and savings for the future.  But, in the process, we should expect ongoing consolidation pain in debt-inflated real estate, education and related sectors.

As cash flows have plunged in the pandemic shutdown, many rents have not been paid and so payments on loans have been missed and investors who own commercial mortgage-backed securities (CMBS) that hold loans from hotels, apartments, offices and retail stores have also not been paid their expected income (Trepp).  This is half the story.  The other half, according to a new whistleblower report, is that widespread banking fraud enabled many property owners to borrow more than they could afford to pay back — even before the pandemic quashed their income.  See Whistleblower:  Wall Street has engaged in widespread manipulation of mortgage funds:

Some of the world’s biggest banks — including Wells Fargo and Deutsche Bank — as well as other lenders have engaged in a systematic fraud that allowed them to award borrowers bigger loans than were supported by their true financials, according to a previously unreported whistleblower complaint submitted to the Securities and Exchange Commission last year.

Whereas the fraud during the last crisis was in residential mortgages, the complaint claims this time it’s happening in commercial properties like office buildings, apartment complexes and retail centers. The complaint focuses on the loans that are gathered into pools whose worth can exceed $1 billion and turned into bonds sold to investors, known as CMBS (for commercial mortgage-backed securities).

In the process, borrowers have qualified for commercial loans they normally would not have, and CMBS investors face the prospects of not just lost income but also crashing security prices.  This destructive loop is reminiscent of financial contagion that swept from borrowers and lenders to investors and property prices in the 2007-09 crisis.

It’s interesting to note that after falling 46% from February 20 to March 23 –compared with a 36% decline for the broader Canadian stock market–the basket of Canadian real estate investment trusts (XRE) has rebounded less than the TSX and remained 33% from its peak as of Friday’s close.  The US real estate ETF (IYR) has followed a similar pattern falling 40% from February to late March, and still 27% lower as of yesterday’s close.  The next few months will reveal more about where capital losses are buried.

It is also why some of the world’s biggest investors (and some of us smaller ones too) are sitting on piles of cash, prepared for once-in-a-lifetime opportunities being unearthed by the pandemic.  See Loaded with cash, real estate investors wait for sellers to crack.