People walk near the New York Stock Exchange (NYSE) in Lower Manhattan on October 02, 2020 in New York City.
Spencer Platt | Getty Images
According to Goldman Sachs, parts of the market are in bubbles, but they are unlikely to shrink the overall market with them when they appear.
The Wall Street firm said the exuberance around special purpose acquisition companies, as well as investor interest in companies with negative earnings, is cause for concern; however, these speculative areas do not pose a risk to the overall level of the S&P 500.
“Market pockets have recently demonstrated consistent investor behavior with bubble sentiment,” David Kostin, chief US equity strategist at Goldman Sachs, told clients. “But these excesses pose low systemic risk to the overall market given their modest share of market capitalization.”
Fifty-six initial public offerings of PSPC have been completed so far in 2021, raising $ 16 billion, notes Goldman. This is in addition to the 229 US PSPCs that raised $ 76 billion in 2020, dubbed the “years of PSPC,” Goldman said.
“The low interest rates, the flexible structure, and the two-year window to find a target before returning capital suggest that the popularity of PSPCs will continue in the near term. It is important to note that we see little risk for public equity markets if investor enthusiasm for PSPCs wanes, ”Kostin said.
It has been a fad in PSPCs as companies shy away from the traditional market for initial public offering, rocked by the coronavirus pandemic and wild volatility. A PSPC is a blank check company created to raise funds to finance a merger or acquisition within a certain time frame. The target business will be made public through the acquisition.
Shades of 2000
There is also bubble-like behavior in stocks with negative earnings with recent strong outperformance, Goldman said. Over the past 12 months, stocks with negative earnings have surpassed the average share by 40%, a ranking of the 97th percentile. Goldman also said the trading volumes of these negative-earning stocks are at an all-time high.
“These companies account for 16% of trading volumes in equities, surpassing the 15% share in 2000. While this surge appears unsustainable, it also appears to pose little risk to the broader market, as these companies represent only 5 % of total market cap, ”Kostin says.
But Kostin sees reasons for not caring about the whole market. He is among the biggest bulls on Wall Street, with the S&P 500 rallying 11% to 4,300 by the end of the year.
Stock valuations are extremely high on an absolute basis, he noted. However, given the low interest rate environment, the S&P 500 is trading below its historical average valuation. Investors view low interest rates as a kind of valuation cushion.
Even economist Robert Shiller, creator of the cycle-adjusted price-earnings ratio or the CAPE index, pointed out that the index shows that stock valuations are “not as absurd as some people think”, provided that interest rates remain relatively low, Goldman noted.
Additionally, the current market lacks the extreme investor leverage that is common in stock bubbles, Goldman told clients. Thanks to unprecedented fiscal stimulus, consumers are rich in cash, with US household disposable income rising sharply in 2020. These excess savings have pushed the debt service ratio to its lowest in 40 years, making large equity inflows funded by cash rather than leverage.
Beware of these companies
Certainly, one part of the market that looks foamy and that could pose a risk to the broader market is that of extremely high growth, multiple multiples stocks, according to Goldman.
“Just like negative income and penny stocks, trading volumes and stock prices with EV / sell multiples above 20x have increased,” Kostin said. “However, these companies are much larger, collectively accounting for 23% of trading volumes in the past month (96th percentile since 1985) and 9% of market capitalization.”
Companies with this high growth ratio (enterprise value to revenue) accounted for 2% of trade in 2019, but soared to 10% in August 2020 when interest rates fell.
“History shows that investors face long chances of outperforming when they buy the top-valued companies,” Kostin said.
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– with reporting from CNBC’s Michael Bloom.