Tracking Valuation Hazards: How risky are markets today?

Tracking Valuation Hazards: How risky are markets today?

During the Covid-19 pandemic, tech and other internet companies have routinely seen good performance as consumers have been forced to work from home, isolate and disregard certain types of discretionary spending. A few notable technology names have seen outstanding performance relative to the market, even though cash flows have been little to non-existent.

With over 20 million live out of sample valuations since 1998 in its proprietary database, Applied Finance wanted to understand the risk embedded in current market valuations. Using the S&P 500 as a universe, we calculated the percentage of firms (by market cap) in the index that have valuations showing at least 50% downside (overvalued firms) and normalized the results relative to its long-term average. We then calculated a 1.5 standard deviation risk threshold to get a better idea of excessive risk taking. The results can be seen below:

Applied Finance Database: 9/30/98 – 7/29/20

At any given point in time, it is normal for 5-10% of companies to have high or excessive expectations.  For example, some firms may not have strong cash flows today, but investors rationally price in higher futures cash flows to reflect superior future prospects.  Google, Facebook, Microsoft were such examples in the past, today the market is making similar assessments for companies such as Tesla, and Shopify. '

We believe that it’s healthy for markets to have a small percentage of names with high expectations, but perhaps not the immediate cash flows to justify their current valuation. Innovation and opportunities are constantly appearing, and both investors and market prices should react.

However, from time to time, markets can become unhealthy with an overly risky appetite. We clearly saw this trend in the late 90’s Tech Bubble, as any firm with dot com in their name was able to receive an overabundance of capital. After over a decade of a low or moderate risk environment, we’ve recently seen valuations cross just over our higher risk zone. This implies that a larger than normal share of S&P 500 companies now have valuations that present significant downside risk. Although we believe that there are plenty of undervalued companies within the index, we are becoming increasingly cautious of excessive risk taking by market participants.