The Great Decoupling

We are now in the midst of what, for many of us, is the most momentous world event we have ever lived through.

In the last 24 hours 5,600 people died from coronavirus worldwide. In New York City, a pre-eminent seat of global power and influence, health professionals are, in their own words, begging family and friends to help them get protective gear. In the last week, 6.6 million people filed for unemployment support in the USA alone.

And yet, amidst this unforeseen humanitarian disaster, the S&P 500 Index sits 28% below all time highs, and our own ASX 200 Index sit 27% below its peak.

In many ways, this is understandable. After all, governments and central banks are completely committed to providing liquidity for financial systems and low interest rates reduce discount rates and inflate asset valuations.

However, by setting the priority on priming asset valuations, governments are harming their populations. In an environment where unemployment is high and economic productivity is low, inflated asset values simply put ownership stakes, whether of property or businesses, out of reach of vast swathes of the population.

This is, in effect an approach that says while we know there is a hole in the balloon, we will simply pump it ever faster and ever harder with air. Once upon a time there was a view that printing money to infinity would have unintended consequences. Now, apparently, market participants are optimistic that as long as governments keep propping up what are fundamentally overvalued financial products (given current world events), everything will be fine.

Meantime, we have no accurate way of valuing assets. Looking to the Australian market, online travel booking facilitator Webjet (ASX: WEB) trades more than 50% higher than the price at which it last raised capital, despite the fact that its revenue has gone basically to zero, and there is a huge range of possibilities when it comes to how long it will take for their business to pick up again.

What was once an incredibly reliably growing business with free cash flow, profits, dividends and a tailwind in globalisation has suddenly become a cash box with a business that is ready to go once the world comes out of hiding (at an unknown point in the future). And yet, superannuation funds and fund management fiduciaries are falling over themselves to own what amounts to a hugely speculative investment. That may work out well for them, and I hope it does, but the level of risk they are taking is through the roof compared to the risk they were taking one year ago.

Software companies serving wealth management industries trade on eye-watering multiples of past profits. Bravura (ASX: BVS) is on a P/E of 24. Netwealth (ASX: NWL) is on a P/E of 43. Praemium (ASX: PPS) is on a P/E of 22. OneVue (ASX: OVH) is on a P/E ratio of over 600. Mainstream (ASX: MAI) trades on 27 times earnings. Their customers will, on average, be contracting, not expanding. New customers will be harder to come by.

Now, with markets down almost 30%, we know most of these companies’ customers have seen their own revenue drop by an equivalent amount, virtually overnight. For some, and on average, the fall is probably worse than that.

In comparison, telecommunications companies, which will be ever more important in a pandemic stricken world trade on similar (or lower) multiples. MNF Group (ASX: MNF) is on 30 times earnings, TPG Telecom (ASX: TPM) is on 20 times earnings, Vocus (ASX: VOC) is on 18 times earnings. Telstra (ASX: TLS) is on 12 times earnings.

What we can observe is that these first group of stocks are leveraged to markets (which have already fallen), because their customers are leveraged to markets. But they trade on growth multiples.

The second group of telecommunications have leverage in the form of debt, but their revenue is leveraged positively to the current circumstances. In an environment where interest rates are low, and banks are bending over backwards for anyone who can pay, these stocks are far less risky, and may even be considered defensive.

The comparative valuations suggest that in many ways the sharemarket is still very much “risk on”. In comparison, as the humans on the ground in infected cities around the world witness the construction of field hospitals, and mobile morgues, they will become very much “risk-off”.

The only way that governments will get people to get back to normal is by supporting them. And the only way they can do that without stoking asset prices is if that support comes at the expense of asset prices. You cannot avoid the tension between capital and labor forever, and if the current event does not call for governments to support labor then we have been completely captured by the corporate class.

And so what is clear is that markets have completely decoupled with the conditions on the ground. That could be because they are correctly predicting improving conditions, or it could be that, as was the case in February, markets – dominated as they are by the privileged – are missing what is happening for the majority of people in society.

Because of this risk I remain as defensively positioned as ever, albeit still net long.

Disclosure: The author owns shares in MNF Group (ASX: MNF)

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