Confused how to trade the second coming of the dot com bubble and a world in which irrational exuberance has hit irrationally exuberant levels? You are not alone. Here is some insight from none other than David Einhorn originating in his latest letter to investors.
The game of Earnings Expectation Conflation continues. It’s a bit like limbo - with a twist. Though the bar gets lowered every round, the goal is to make it over the bar, rather than go under it. Here’s what the current round looks like: At the end of June, third quarter S&P 500 index earnings were expected to grow 6.5%. In July, as actual earnings started to come in and companies lowballed the next quarter’s guidance, index earnings expectations were likewise adjusted lower. As more companies reported “beat and lower” earnings, market expectations continued to fall to the point where third quarter index earnings growth is now expected to be half of what was forecast in June. Of course, when earnings are announced in October and they “beat” the guidance set in July, everyone will celebrate with cake and ice cream. (Never mind that the earnings are actually in line with the original June predictions, or that they’ve lowballed guidance for next quarter – if anyone noticed that, they wouldn’t be able to move to the next round by lowering the December bar, which is currently set at 13% growth.) As the S&P 500 index has advanced this year mostly through multiple expansion, the index is no longer cheap, particularly considering that we are now almost half a decade into an economic expansion and earnings growth is unexciting.
There is evidence of much more (and increasingly creative) speculative behavior. Some companies have convinced the market to embrace earnings reports that ignore what they must pay employees to show up to work every day, provided the employees accept equity rather than cash. We don’t understand how some investors view this as economically different from the company selling shares into the market and using the proceeds to pay workers. Then there’s the sizable group of companies (including a number of recent IPOs) that are apparently not subject to conventional valuation methods. Many have no profits and no real plan to make future profits. The market doesn’t seem to mind – in fact, it is hard to fall short of such modest expectations and the prices of these stocks have performed particularly well of late. Finally, there are the market participants whose investment process appears to be “bet on whatever has made money most recently.” They’ve noticed that stocks with large short-interest ratios have materially outperformed over the last year and they continue to invest accordingly. When “high short interest” becomes a viable stock-picking strategy and conventional valuation methods no longer apply for many stocks, we can’t help but feel a sense of déjà vu. We never expected to find ourselves in an environment like this again, given the savings that were lost when the internet bubble popped.
We are happy (and sad) to take the blame for #3 (see "Presenting The Best Trading Strategy Over The Past Year: Why Buying The Most Hated Names Continues To Generate "Alpha"). After all, when dealing with a stock market designed by a bunch of clueless Princeton academics specifically to cater to idiots, one must trade accordingly.
Finally for those wondering...
At quarter end, the largest disclosed long positions in the Partnerships were Apple, General Motors, gold, Marvell Technology, Oil States International and Vodafone Group. The Partnerships had an average exposure of 109% long and 72% short.
We must say: we admire Mr. Einhorn's testicular fortitude to hold a 72% short position in a world in which all "downside risk management" has been outsourced to the politburo in the Marriner Eccles building.