The stock market is not yet detached from reality but risks are increasing

For many weeks now a debate has raged about the surging recovery of stock markets when compared with the dire state of economies. How can share prices keep going up when companies are closed for business and millions of people are either losing their jobs or are reliant on government schemes to provide them with money to live on?

For the simple reason that stock markets are driven by flows of money and the Federal Reserve in America has created lots of new money. 

This is nothing new. It is a continuation of a trend that has been going on since the financial crisis more than a decade ago, but the scale of money creation currently is unprecedented. Investors are still faced with little alternative to shares in a world where there are few inflation-beating returns on cash and many government bonds.  

The foundations for share prices to rise is therefore still intact. If you accept this view then stock markets are not disconnected from reality but are just rationally adjusting to a set of rules that have been heavily tilted in their favour. However, that’s not the same as saying that everything is fine with the world. It isn’t.

The big beneficiaries since the March low have been the same shares that have been driving markets upwards for the past decade. Investors have flocked to quality growth stocks where they are attracted to companies that are very profitable and have significant market power – some might say too much – but also are seen to have the capability of continuing to grow their profits and cash flows. They also have proved to be more defensive in tough times, which means investors continue to be happy to pay up for increased peace of mind.

This trend is most striking in the shares of big technology companies on the US stock market, where the Nasdaq has hit record highs again this week. Over the past week the rally has also broadened out to include beaten-up stocks seen to benefit from a rapid economic recovery.

Much of the concern of stock market bears is that valuations are too high. This is true when comparing valuations against historical long-term averages, but maybe not in today’s world.

If we look at the free cash flow yield (free cash flow per share as a percentage of the share price) as a measure of valuation of the 10 biggest Nasdaq shares then valuations of some shares are very high – they have low yields.

Nasdaq Top 10: Trailing 12-month (TTM) free cash flow yield

Source: SharePad

However, in many cases they also have the potential to grow their free cash flows in the years ahead. This will mean that the free cash flow yield on cost on today’s share price in the future could look very attractive.

In very simple terms, buying immensely powerful business franchises on trailing free cash flow yields of 2-3 per cent may look like seriously overpaying compared with the not so distant past, but when you compare them with US 10=year Treasury bonds, which offer no cash flow growth and have a yield to maturity of 0.82 per cent, then they look relatively very attractive. This argument holds as long as the anticipated growth in cash flows comes through. 

As far as technology is concerned then the bulls have some very strong arguments. The coronavirus lockdowns have opened the eyes of many more people to the power of technology to increase their productivity and make their lives easier in a changed world. Those companies with dominant technology franchises such as Microsoft and online retailing expertise such as Amazon.com may well be the best placed to monetise this trend and it could happen faster than people think.

Turning to the UK, we see a similar theme in that quality growth is priced very highly with low free cash flow yields. Again, with 10-year government bonds offering a yield to maturity of just 0.38 per cent at the time of writing the argument for owning these types of shares is still strong.

UK quality growth stocks: TTM free cash flow yield

Source: SharePad

What can bring this trend to an end?

Quality growth stocks have been a great way to gain and preserve wealth and are likely to remain so over the long run. However they continue to become an increasingly crowded trade. which is great for existing shareholders but maybe not so great for anyone just buying in. This is key because this has become a big momentum trade that needs more fuel to keep it going.

Can the good times last?

Falling profits or lower profits growth is the obvious risk given the battering that economies have taken from lockdowns. However, there are other forces that might bring this surging stock market run to an end.

A big concern is that the US stock market is addicted to an ever-increasing supply of cheap money from the Federal Reserve. Many think that the size of the Fed’s balance sheet is unlimited and that it can print unlimited amounts of money. This is true in theory, but there are no free lunches in the world of economics even though what has been going on recently might seem like one.

It should not be taken for granted that the creation of trillions of fresh dollars out of fresh air can be done without affecting the value of the dollar itself. If we look at the dollar index, which compares the value of the dollar against a basket of currencies, the initial flocking to the dollar at the stock market lows in March has turned to fleeing over the past week or so as worries increase that there may be too many dollars sloshing about and more might be on the way.

A UK investor with a lot of exposure to US stocks – or UK companies with lots of US dollar profits – will also be feeling the pain of this as the fall in the value of the dollar and rise in the value of the pound is making those investments worth less in pounds.

The money printing from central banks after the financial crisis raised fears that inflation would take off. It did, but only in terms of share prices, bond prices and property prices. The prices that people paid for everyday essentials did not go through the roof.

At the moment central bankers are concerned with falling prices – US annual inflation was only 0.3 per cent in April – but a sustained fall in the value of the dollar would push up the prices of imported goods and increase the rate of inflation. How would expensively valued shares fare then?

If US inflation was to increase even to a modest level of 3-5 per cent then stocks currently trading on free cash flow yields of 2-3 per cent would have zero or negative real yields after inflation. They would arguably need to increase their potential rate of growth to remain attractive to investors.

Some companies might be able to increase prices, but if the incomes of their customers don’t keep pace with rising prices then their ability to buy the goods and services of companies diminishes. It’s not easy to grow profits in an environment like this.

A big structural shift in working and living habits combined with very low inflation would be a great outlook for US tech stocks, but this assumes that the Federal Reserve can keep all the plates spinning in terms of flooding markets with money without creating inflation and trashing the value of the dollar. It may keep getting away with it for a while longer and betting against the Federal Reserve has been painful, but dark clouds can be seen on the horizon.