Components of the market are in a bubble however pose little threat to the S&P 500: Goldman
People walk past the New York Stock Exchange (NYSE) in Lower Manhattan on October 2, 2020 in New York City.
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Parts of the market are in bubbles but are unlikely to bring the overall market with them if they burst, according to Goldman Sachs.
The Wall Street company raised concerns that the exuberance of special-purpose acquisition companies and investor interest in companies with negative earnings are a matter of concern. It added that these speculative areas pose no risk to the S&P 500.
“Pockets of the market have recently shown investor behavior consistent with the bubble-like sentiment,” Goldman’s chief US equity strategist David Kostin told clients. “However, due to their small share of market capitalization, these excesses represent a low systemic risk for the broader market.”
Fifty-six SPAC IPOs completed as early as 2021, raising $ 16 billion, according to Goldman. This contributes to the 229 US SPACs, which grossed $ 76 billion in 2020 in what has been dubbed the “Year of the SPAC”.
“Low interest rates, the flexible structure and the two-year window to find a target before the capital return suggest that the popularity of SPACs will continue in the near future,” said Kostin. “The important thing is that we see little risk to public equity markets should investor enthusiasm for SPACs wane.”
It has been a mania in SPACs as companies shy away from the traditional IPO market ravaged by the coronavirus pandemic and wild volatility. A SPAC is a blank check company created to raise funds to finance a merger or acquisition within a specified period of time. The target company will be listed on the stock exchange through the acquisition.
Shadow of 2000
There is also bubble-like behavior in stocks with negative earnings and strong outperformance recently, Goldman said. Over the past 12 months, stocks with negative earnings have outperformed the average stock by 40%, a 97th percentile ranking. Goldman also said the trading volume of these negative earnings stocks is at a historic extreme.
“These companies account for 16% of the equity trading volume, exceeding 15% in 2000. While this increase does not seem sustainable, it also appears to pose little risk to the broader market as these companies account for only 5% of total market capitalization. “said Kostin.
But Kostin sees reasons not to worry about the overall market. One of the bigger bulls on Wall Street, he’s forecasting an 11% rally in the S&P 500 to 4,300 by year-end.
Stock valuations were extremely high on an absolute basis but added that given the low interest rate environment, the S&P 500 was trading below its average historical rating. Investors see low interest rates as a kind of evaluation cushion.
Even the economist Robert Shiller, who created the cyclically adjusted price / earnings ratio, or the CAPE index, pointed out that the index shows that stock valuations “aren’t as absurd as some people think,” assuming that Interest rates remain relatively low, Goldman noted.
Also, the current market lacks the extreme investor leverage that is common in stock bubbles, Goldman said. Thanks to unprecedented fiscal stimulus, consumers are rich in cash and the disposable income of U.S. households soared in 2020. These excessive savings have brought the debt service ratio to its lowest level in 40 years, with the strong capital inflows being funded by cash rather than leverage.
Beware these companies
One part of the market that appears foamy and could pose risk to the broader market is extremely high growth, high multiples stocks, according to Goldman.
“As with bad earners and penny stocks, the trading volume and stock prices of stocks with an EV / sales multiplier have increased over 20x,” said Kostin. “These companies are much larger, however, and collectively account for 23% of trading volume last 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 rose to 10% in August 2020 as interest rates fell.
“History shows that when investors buy the highest-rated companies, there is a good chance they will outperform,” said Kostin.
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– with reports from Michael Bloom of CNBC.