IPO Frenzy a sign of Froth? What do Market Internals tell us? (FINANCIAL HORSE)

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IPO Market is on fire:

• Snowflake tripling since IPO

• AirBnb doubling on IPO

• Doordash doubling on IPO

• JD Health up 50% on IPO day

• Palantir up 150% since IPO

New IPOs into this market, especially those with exposure to “disruptive” tech, has been doing very strong. Even closer to home, something like Nanofilm is up 50% since IPO. And in the US the specutive SPACs are all very strong.

IPO Frenzies are usually a sign of the top / late cycle

It’s interesting because in almost every past cycle a hot IPO market, and excessive retail investor participation is always seen at the late cycle, and not at the start of a new cycle. We saw this in the late 1980s, the late 1990s, the 2005-2006 period, and we’re seeing this again today. Throw in the fact that just 9 months ago we were in the fastest bear market of all time, and it just makes 2020 all the stranger.

What does history tell us?

So I pulled up a bunch of charts to try and figure out what history tells us.

The chart below shows the points where more than 90% of S&P500 stocks trade above their 200 DMA (as it is right now).

Historically, when that happens, stocks usually trade experience a short term decline – with the decline being anywhere from 6% to 19%.

When stocks are at 98th percentile above their 200 DMA - stocks either have a short term drawdown, or they trade rangebound for a period.

A composite valuation score from one of the macro guys I follow (inputs are a blackbox so we won’t know exactly what goes in).

But the takeaway here is that usually when things get this bullish, short term returns from 3 to 9 months out tend to be negative, but 12 months out they tend to improve.

Breadth momentum is also really strong. And historically, such strong breadth momentum is usually not a sign of a bear market rally, or a market top. Most of the time, this happens within a broader bull market and higher highs lie ahead - But with a risk of a short term drawdown.

What does this mean?

It’s quite a lot of information to digest, so I’ll sum it up.

What history suggests, is that:

• When sentiment is this bullish (based on stocks above 200 DMA), stocks usually have a drawdown or stay rangebound for a while (6 to 12 months)

• When breadth momentum is this strong, it usually means we are not in a bear market rally or a market top. It’s usually part of a broader bull market with higher highs ahead - But with the possibility of short-term drawdowns.

• Certain segments of the market (esp IPOs and disruptive tech) are showing bubble like tendencies (qualitatively). Retail participation in the market is also at an all time high, which is short term bearish.

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Is this time different?

Of course, past performance is no indicator of future performance. So take all of the above with a huge pinch of salt. There could be any number of reasons why this time is different. Maybe the stimulus will kick in, maybe the vaccine drives insane consumer demand, maybe retail sentiment has distorted the market.

What to do as a long term investor

As always, what to do as an investor depends on your holding period.

• Short term – Data suggests there is a possibility of a short term pullback or drawdown. So from a tactical perspective, some caution is warranted. But these are averages, and individual counters can still outperform the market.

• Mid term – Incredibly strong breadth momentum suggests this is part of a broader bull market, and that this is not a bear market rally or a market top. Macro wise, I would be inclined to agree with this as well. Mid term holdings 12 months out are likely to deliver positive returns (again these are averages, not individual counters).

• Long term – Data doesn’t reveal any insights in the long term. But once you zoom out big enough, most indexes are upward trending in the longer term. For eg. - Even if you bought the S&P500 in Sep 2008, right before Lehman, you’d still be flat 5 years later.

Macro perspective – the Insolvency Phase

I also had a bit more time to digest the Phase 3 news. And my latest thinking about the next phase is that governments will need to decide who to let live, and who to let die.

The underlying problem here is that consumer demand habits have shifted permanently. Like we talked about earlier this week - some retail demand has moved online permanently, and some office demand has moved to flexi-working permanently. The problem so far, is that the government has bailed everyone out on a blanket approach. So everyone is kept afloat, without regard to how healthy their underlying P&L is.

In 2021, governments will need to start making decisions on which industries have been permanently changed, such that saving the companies there no longer make sense – because it will never stand on its own 2 feet anymore.

Government bureaucrats will need to become kingmakers – deciding who lives and who dies. So there will be insolvencies, and the focus is on managing the process – ensuring that the insolvencies don’t happen all at the same time such that it comes as a shock to the system. So you want to give the economy time to adjust structurally via a managed process, with stimulus being withdrawn gradually (eg. the workers in the shop that closes can move to an eCommerce player).

The net effect of this though – is that real GDP growth will be slow for the foreseeable future, as the economy manages this structural transition. Year on Year GDP will be high of course because 2020 was such a low base, but compared to the pre-COVID trend it will slow down noticeably.

Closing Thoughts

What I would probably add to this discussion is the importance of asset allocation.

With the kind of uncertainty we’re facing both short term and 3 to 5 years out, it’s just impossible to predict with certainty how everything is going to play out.

I do think a diversified portfolio just makes a lot of sense right now.

Some stocks (value and growth), REITs, real estate, bonds, gold, and enough cash to cover living needs, just makes a lot of sense to me (we cover this extensively in the FH Complete Guide to Investing - Xmas Promo right now!). You can overweight certain asset classes based on risk appetite, but the underlying allocation should still be broadly diversified to begin with.

Would love to hear your thoughts though! What am I missing here?

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