Arun S. Chopra CFA CMT
The big story last week was obviously the declines in software and momentum stocks. The big story for the year has been the bond market and overall move in yields. With the steep decline in rates in the US and the move to negative rates abroad, there has been a lot of confusion in equity positioning and market outlooks.
Today I will walk through the move in bonds, and the specific relationship to software and momentum names, as well as how (and why) I saw a lot of these breakdowns setting up in advance. I will primary focus on the making of, and thinking behind this trade in general, and conclude with some charts on the stocks themselves.
This will not be a larger investment outlook on the space or the stocks themselves but more of a review of how I believe we got here and how I managed through it.
Negative rates certainly caused a lot of confusion. From who I tend to follow, consensus seems to point to a bearish conclusion. Essentially the classic message of the bond market.
The global slowdown (macro data) and deflationary element to lower rates can be seen in weakness in commodities (CRB) and the sluggish copper price, amongst other sectors, subindustries, and asset classes. So that's certainly a thought.
At the same time the lesser-told story in 2019 has been the sharp rallies in typically economically sensitive spaces like the Baltic Dry and Semiconductors (SOX), also as rates have declined. You could add HYG and some cyclical subindustries (after this week especially) to this list.
Taking this a step further, we saw trucks rally sharply this past week. The Dow Jones Trucking Index (DJUSTK), particularly the basing action, had been a key focus at Fusion Point all summer so it was nice to see them move. Even better when the majority are left scratching their heads a bit.
Growth Vs. Defensives
But how does any of this matter to software stocks?
Well, from my sense of it, primarily because the decline in bond yields has not been just a "risk off" event. It has actually been both risk on and risk off, depending on the participant. And that risk on component quietly impacted software stocks the most, which was the setup for the fall in the first place.
I've argued most of the summer that one impact of negative rates was to take both risk-averse and risk-tolerant participants and force them as far out on the risk curve as they can go (yes all over again). Essentially everyone increased duration (see software valuation math below) vs a market wide risk off.
Let's visualize it. The chart below shows Procter & Gamble (PG) and Twilio (TWLO), one defensive, one software/growth name to show this dynamic. Both groups have been heavily influenced by the move in yields, which makes "some" economic sense when thinking about risk taking vs. the cost of capital. Defensives got further forced into the yield chase, while top-line growth/momentum basically traded as if money were free.
So yes, money moved into bonds (and defensives), but it also moved into high growth/software/momentum names. What's more striking is how correlated the move has been.
This has naturally led to pretty lofty valuations and aggressive multiple expansion. So much so I started building a thread on twitter called "#Stonks" as a play on the sort of the craziness of some of the pricing we were seeing.
The thread itself (not shown) was built around software and other momentum multiples that started to go haywire in the summer of this year. By haywire, I mean past 20+Xs sales and into the 30s sales as in the MarketAxess Holdings (MKTX) case below.
A rudimentary back of the napkin calculation says that at 30s sales, one would need an approximate 50% growth rate and a 50% cash margin (CFO-CFI) for eight years straight just to break even.
Yes, some of these are growing faster, and obviously there's a lot more to valuation (including technology, network, TAM, competition, patents and so forth). This is just to give a sense of how challenging it is to make sense of 30Xs revenue as an "investment" today, mathematically speaking.
Generally, at 30Xs sales people are paying the value they'd receive/build if the same company hit every fundamental metric (customers, margins, moat and so forth) perceived as available in the market today, in the future. Basically it's the opposite of a margin of safety.
Luckily we have momentum and intermarket to better explain what's going on.
The night before the selloff I posed this question on Twitter. Although obviously a small sample, I wanted to see a bit about sentiment, particularly with respect to valuation. As you can see more than 50% of respondents feel application software names should trade at 20X sales or higher.
If we look at the application software companies price to sales multiples across the space, one thing is apparent. The upper box (20-30Xs sales) has been starting to fill (with relatively large name, note circle size = market cap).
Again, to be clear, there's a tremendous amount more work (and guesswork) that goes into what a multiple should be, even across the same subindustry. It's outside the scope of today and I'm sure there are reasons bulls on any of these would have for each being priced where they are.
To that end, MKTX took off right as German yields collapsed. Yellen has referred to this as "spillover" effects from global policy. Note the correlation at the bottom, which not only is -.92, but has been negative for nearly a year.
When thinking about intermarket analysis and what's driving price action across different asset classes, in this case yields became paramount. As the largest, most liquid, and macro market, it tends to impact everything else. Sometimes very aggressively, as shown below.
MKTX's multiple nearly doubled while US longer term interest rates fell sharply as well.
Below I have overlaid MKTX's price to sales with the US 30-year bond yield. This chart speaks to the aggressive multiple expansion as rates dropped (and went negative abroad).
Included here is Shopify (SHOP). We can take some of this analysis a step further and look at changes in market cap vs. changes in revenue, overlaid again on the longer-term yields chart.
You see effectively the same relationship but also can visually see market cap far outpacing revenue growth (multiple expansion).
One really good thing about intermarket analysis is you can see beyond the micro view of the world. More on why that matters below.
Pros Holdings (PRO) is another good example of this expansion. PRO has seen a 1K% move in its market cap relative to a 200% change in revenue. Further, the near doubling in market cap came during just this rate decline driven move alone. This came mostly post earnings, but the key takeaway here is when rates are negative, everything is amplified.
This leads back to one of my more favorite charts and reasons I use multiple disciplines. Valuations are volatile. There's a large amount of subjectivity to public market valuations (even without intermarket impacts). This can be explained by many things beyond company products, growth, and outlooks such as intermarket, liquidity, and momentum.
Software Stocks Hit as Yields Rise
Back to the larger trade. Once the trade driver is/was located, that becomes the key anchor to the rest of the complex.
For those who haven't used proxies before, they are just a combination of assets (or just one asset) or some relationship between two assets (ratio) that attempt to explain or predict a move in another, often most important, asset.
In this case bond yields are the asset I'm monitoring, and my proxy is then designed for that. You can see below that my proxy essentially has been screaming dislocation all summer.
The safest trades are naturally a convergence between these two, but the next step was to say, OK, what if rates actually rebounded? Enter software stocks as a short.
So by now hopefully I've walked through it, but essentially rates went negative and everyone chased high growth names to valuations that make limited sense. From there, my bond proxy was signaling that the move in yields to the downside was itself dislocating (diverged from proxy).
The next step was to use another proprietary tool which is my buy/sell pressure indicator. I will have more on this in the future as we are currently using it for members today in two different versions (part of the service and as a standalone).
The key point is once a trend gets excessive (price, momentum, valuation etc) there should be an end point. That is fine and good. We know sentiment gets frothy. We know everyone is talking the same stocks (we may not even know, or there may not be an easily identifiable trade driver). We all know what selling the bottom and buying the top feels like. But that phenomena is not enough. Sentiment is just a condition, not an actionable event. Anyone who has tried to countertrend based on sentiment alone knows what I'm talking about.
I spoke about this indicator more in depth in my article on Micron (NASDAQ:MU), The Micron Dump, which also signaled nicely as everyone dove in above 60. Below is an excerpt from this summer just to show we saw exactly what one would expect to see prior to a giant reversal across assets.
Illinois Tool Works (ITW) is a more cyclical name, while PRO is obviously one of the software runners I mentioned. You can see some of the communication and signals we saw prior to the reversals. To be clear, selling pressure is bullish (people are capitulating out) and buying pressure is bearish (people are panic buying).
Lastly, the trade. Here's some member video from two weeks prior to the breakdown. Often people will show a chart breaking or something of that sort, but I wanted to walk through the entire trade context first to show that by the time this video was made, it really wasn't about the price pattern as much as a potential unwind in the whole space. The potential was high, the pattern and the charts were just the tools and levels that would likely move the space.
And here was the day after the initial breakdown, where we looked more in depth that the critical levels prior to liquidation. I often say a good area of untapped big trades is to study how momentum breaks. This is much easier said than done because every circumstance is different (which is why the payoff is big too). I showed a similar momentum break with different intermarket drivers (fed balance sheet) in my Nividia (NVDA) article The Nvidia Dump.
Software stocks were hit hard. They were running with a very high correlation to bond prices and inverse to bond yields. German yields being negative probably put an even further emphasis on these names than normally would.
The break of that fever caused tremendous dislocations in these names. By using intermarket analysis, sentiment, proxies, capitulation, and classic chart formations, you can hopefully see how this came together.
Current chart wise for those who I'm sure will want to know, many are broken. For my longer-term outlook on the space, I'd probably say refer to the back of the napkin calculation above (broadly speaking). For some really simple charts to show the damage here are 3. For traders you can also see the precision of the liquidation points across the longer time frames.
MKTX breaks way outside of trend:
TWLO trend break and flag:
Okta Inc (OKTA) clean trend break post the rounded top:
Shorter term and technically speaking, the correlation to Bunds (German bond prices) is probably a decent thing to watch. I suppose the good news is there is a convergence point coming. Given the relationship over the last couple years I'd expect that to continue at least in the nearer term.
Performance continues to outperform at Fusion Point. There have been some significant downshifts in risk exposure in the last few months, offset by momentum/macro shorts and value driven longs. I continue to look for opportunities utilizing fundamentals, technicals, and behavioral finance.
Thanks for reading..