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Written by: Tim Pierotti
On the most recent “Masters in Business” podcast, Greenlight Capital’s David Einhorn said, “I view the markets as fundamentally broken. Passive investors have no opinion about value. They’re going to assume everybody else has done the work.”
Einhorn, a world class poker player, built his hedge-fund empire from a modest start of $1mm of capital to a powerhouse on Wall Street. He describes himself as a stock analyst and a value investor. For more than a decade he put up outsized returns with the most tried-and true of long-short hedge fund strategies. Find stocks with very low multiples of free cash flow that you believe will grow faster and be more cash generative than consensus believes. Conversely, on the short side, find stocks with high multiples where perhaps you see a deceleration versus a complacent sell-side that assumes continued growth. Most famously, Einhorn loudly and correctly made the bet that Lehman Brothers equity was essentially worthless well before that was evident to the NY Fed, employees, and their creditors.
But, in more recent years, Greenlight and Einhorn’s performance had struggled. Eventually, he came to understand the emerging shortcomings of his traditional method that trusted the market would remain relatively efficient: that individual company performance and the multiple awarded would rhyme. He believes there has been a change in individual stock behavior that has been all about the inexorable share growth and dominance of passive money. Passive investing products (Vanguard Index Funds, the SPY and QQQ, etc) have grown to a point where market dynamics have shifted from one driven by value and fundamentally driven mean reversion to the inflows and outflows of 401k, ETF, Passive Mutual Funds etc, and the savings and sentiment of “the man on the street”.
In the podcast, he cites Simplify’s Michael Green, a Wall Street Veteran of equity derivative desks and Long-Short Hedge Funds, as the person who helped him understand that he needed to change his approach. Einhorn is hardly alone in being impressed and influenced by the brilliant, scholarly and unusually articulate Green. Regarding the Einhorn podcast comments Green wrote, “It was a tour de force discussion about a transitioning world dominated by passive strategies and how to manage money in an environment in which the marginal bid is not considering “fair value” in any manner.”
Green and Einhorn’s views are evidenced by the fact that a quarter of the value of the S&P 500 is concentrated in five stocks. The S&P is making new highs above 5000 while the small and midcap IWM is still 20% off it’s all-time highs. They make the case that passive flows are value agnostic, simply directing money on a market-cap adjusted basis. The result of that is the big get bigger. More multiple growth begets more multiple growth. As retail investors are wont to chase momentum, a disproportionate share of assets flow to Large-cap growth. Additionally, Green has illustrated that while the Mag 7 stocks are obviously “liquid”, their average daily volume as a percentage of their market caps is less than that of the average of the other 493 stocks and therefore the incremental share of assets that flow into these names is more impactful to their share price.
But all that said, the concentration in the value of the S&P in the Mag 7 is not just a reflection market structure but also the stunning dominance of just a few companies. Just consider how much you spend every month with just Apple and Amazon. Technological innovation has powered those companies into virtual legal monopolies and that is unlikely to change anytime soon. That said, consider that Apple trades at almost 30x earnings and 8x sales despite the fact they no longer have topline growth and face truly significant geopolitical (Chinese production and sales) and regulatory risk.
On the other hand, as Einhorn laments, you can screen for literally hundreds of sub $5billion market caps with durable double-digit free cash flow growth and multiples under 15x, half the Apple multiple. The IWM index trades at roughly 12x earnings versus the S&P at 22-23x earnings. Historically, the opposite is true. The S&P usually trades at discount to the IWM for the intuitive reason that smaller companies tend to have faster growth potential than larger companies.
So, what does all this mean for the S&P? In the immediate term, consider that the retail investor base, on average, is meaningfully wealthier than before the pandemic and before the creation of $8 trillion of Fed monetization and before the recurring $2 trillion of deficit spending. Wages are growing in real terms. Houses are worth more. If they own a small business, they have enjoyed unprecedented governmental support, and it’s very possible that their baby boomer parents have begun the generational transfer of wealth. The Fed not easing is a concern of many, but those who have argued that monetary policy has become a backstory relative to the fiscal expansion seem to be getting it right. (Hat tip to our own Bull & Bear Podcast guest George Robertson)
Therefore, the S&P may well continue to rise until the economic backdrop slows considerably. That doesn’t mean I like the risk/reward for long-term investors. It means, if I were in the shoes of Mr. Einhorn, trying to put up monthly returns, I would respect the momentum of both the economy and the flows. But ultimately, these market dynamics don’t mean that there won’t be mean reversion for those stocks that are over-valued or under-valued, it just means that the near-term dynamics are less efficient, and it has likely put us into a scenario that very little potential bad news is priced in for the largest companies.
What if AI doesn’t beget significant productivity growth? What if the consistent monthly loss of full-time employment, falling JOLTS and temp staffing weakness really are a harbinger of a weaker labor market? What if there is a global wealth effect to the slow-motion collapse of the world’s single largest asset class: the Chinese property market? What if the impact of monetary tightening is just slower this cycle and the slow but persistently higher cost of capital for businesses does crowd out investment spending? What if the long end of the curve breaks down due to our federal government’s abdication of any prudent fiscal stewardship. What if…
As my old Macro hero Barton Biggs said back in 1999 (paraphrased from recollection): “Bear markets don’t knock. They sneak into your house and steal everything before you have a chance to do anything about it.” I doubt that has changed despite the new market structure at play. Bull markets are about optimism. Bear markets are about pessimism. The risk is that the wisdom of markets may have given way to the madness of crowds. What begets that pessimism, I don’t claim to know. But, when we do see it, be prepared. The greatest traders in the world can’t pick bottoms or tops. They buy the speculation and greed phases of bull markets for sure, but they take profits, and they buy some protection along the way.