1/ The common perception is that Fed's pivot will lead to multiple expansion and a fresh round of asset bubbles. Investors recall the second half of 1998—the last time the Fed switched to a more dovish stance in the middle of a fairly robust economic expansion.
2/ Back then, the Fed cut rates three times following the spectacular collapse of hedge fund Long Term Capital Management. What followed was a melt-up in equities, the S&P 500 gained 19.5% and the Nasdaq rocketed 85% in 1999.
3/ We think the outcome will be different this time. The confluence of an aging economic cycle, fading fiscal impulse, weak CEO confidence, peak profit margins, negative currency translation effects on earnings, and rising political uncertainty will lead to a valuation derating.
4/ Consensus estimates 9% earnings growth for S&P 500 companies in 2020. But analysts are way too optimistic and have generally cut forecasts by an average of 8% over the last 30 years. We see earnings downgrades and a collapse in forward multiples next year.
5/ Valuations have already peaked for the cycle at last year’s January high. The forward PE multiple (17.5) is well above the 5-year average (16.6), 10-year average (14.9), and 25-year average (16.1) yet still below the 2018 valuation peak (18.5).
6/ Historically, the best combination for multiples has been strong growth and low inflation. But when we look forward, we see a world of below-average growth and above-average inflation. A higher multiple is harder to sustain in a more volatile environment.
7/ It is worth noting the “melt-up” is already occurring—its just in private markets with unusually rapid string of funding rounds. DoorDash is now valued at $13 billion from $1.4 billion in early 2018. Robinhood has a $7.6 billion valuation from $1.3 billion two years ago.
8/ But as @CBinsights notes the average multiple on $1 billion+ exits has fallen from 16.1x to 6.9x—a 57% drop in just five years. The Exit-To-Raise multiple, the ratio of money invested into the startup to its valuation at exit, has plummeted.
9/ As institutional investors funnel unprecedented amounts of capital into Silicon Valley, the reality is startups are showing signs of being unable to turn that capital into greater value. This is because growth is getting harder and hacking tactics are now less effective.
10/ As @andrewchen notes “It’s easier to just spend more. It’s much harder to fix the underlying issues—creating real moats, product differentiation, doing deeper adtech integrations.” Hence, capital raises at every stage have more than doubled since the beginning of this decade.
11/ VC funds are getting bigger and bigger as result, feeding into this cycle of capital abundance. This always happens at the tail end of the cycle and promises lower future returns. Public and private markets are tied at the hip. Each day brings us closer to the end.
