It’s not over yet

Where do bounces come from in a midst of a correction?

Sometimes it’s just that stocks have fallen too far for sellers to want to keep selling. This isn’t bullish. In fact, this type of bounce can suck people back in by creating the appearance that the worst is over. Growth stocks in particular. Because belief dies hard and enthusiasm for cutting edge technologies fades slowly, not suddenly. Which mean the give-up process is long and drawn out – even after a stock is cut in half sometimes the worst is still yet to come. The slow bleed after is often worse than the initial shocking drop that preceded it.

Over at Verdad Capital, Dan Rasmussen revisits their “Bubble 500” list of overpriced growth stocks, originally created in the Summer of 2020. It’s filled with money-losing companies working in exciting areas of technology such as electric vehicles and gene editing therapy and so on. Needless to say, this list of bubble stocks has gotten absolutely destroyed year-to-date, after having run straight up in Verdad’s face through the middle of 2021.  Dan explains two very important things in his update this week: The first is that sell-offs for growth stocks differ from sell-offs for value stocks in one very important way:

This breakdown is significant, especially for growth stocks. Remember, growth stocks trend, and value stocks mean revert. The psychology is simple. People hear about a hot stock that’s gone up 3x, they buy some, it goes up 2x, they buy more: the whole attraction of buying a hot growth stock is the historic return trajectory. Value stocks are the opposite: you do well buying them when they’re down…

This idea is counterintuitive – that some stocks actually become worse buys as they are falling to lower prices, but the explanation is psychological, not financial. Stocks trading at excessive valuations require a fan base to sustain their share prices. That fan base is often a bandwagon-jumping melange of traders and investors who are attracted to recent gains. Yes, they’ll latch onto the fundamental story, but the fact that the stock has been and currently is going up is the main thing. When the stock breaks, so too does the fandom. And when the fan base moves on to greener pastures or runs out of money, a new fan base will not form for this stock with its chart in decline. Broken growth stocks become orphans. There is no natural place for them to find a home.

Dan’s other point is equally important: There’s a lot of room between where a broken growth stock can fall from and where a more value-oriented buyer might be compelled to take a look. In the case of the Bubble 500, you could drive a truck through current valuation and an attractive entry point for fundamental investors, even after the recent plunge!

And so, once the trend gets broken, once the magic of the rising stock prices disappears, it’s a long way down until valuation becomes the justification for buying. And the Bubble 500 stocks still trade at wild valuations: FuelCell trades at 16.8x revenues, Blink Charging trades at 44.3x revenues, and MicroVision trades at 161.3x revenues. The median company trades at 12.2x sales, offers a -2.5% earnings yield, -7.5% return on assets, and -14.0% net income margin. Analysts remain bullish, assigning the median Bubble 500 company two-year forward revenue growth estimate of 20.8%.

This is where we are now. The spread between growth stock valuations and value stock valuations (based on enterprise value to EBITDA or cash flow) is still at a record high. So there’s a long way to fall for the most expensive cohort within the growth stock bucket before the value players find them cheap enough to be worth buying. The unprofitable companies will find it nearly impossible to attract support from this crowd.

This is why the easiest assumption to make is that the correction in hyper-expensive, extremely speculative growth stocks will continue even after the overall S&P 500 has found a bottom. These stocks will occasionally stop selling off as they get “too low” in the eyes of the holders, and short-term rallies will occasionally keep hope alive. But these rallies will be to lower highs than the old highs before the stocks roll over again. It’s painful to watch and even more painful to live through. I will be living through this myself with a couple of names I am still holding onto personally: Roblox, Matterport, ChargePoint – broken growth stocks all at the present moment. I will not be expecting anything good from them in the near-term. Especially compared to Berkshire, my REITs, my banks, etc.

All of which should be a reminder for why diversification is more important than almost any other consideration when constructing a portfolio. A portfolio betting exclusively on the most expensive, exciting stocks would have looked great from the spring of 2020 through the fall of 2021. Unfortunately, this same portfolio is now doing far worse than one that more closely tracks the major indices, or has been weighted toward something other than growth – quality, value, dividends, any of these would suffice in the current market environment. Eventually, the bifurcation between stocks that are done going down versus stocks that aren’t will become more obvious. There are still a lot of younger, less experienced investors hanging onto the latter group of stocks and learning this concept for the first time.

And because there is still such a chasm between where growth stocks are currently valued versus where they may look more attractive to the next wave of potential buyers, it wouldn’t be a surprise to see this bifurcation continue for longer, despite the carnage in the space we’ve already seen.

Source:

Bubble Stock Meltdown (Verdad)