TSP

It remains to be seen if this is just a small correction that will be bought, or if it’s the start of a larger drop. Either way, given the combination of high equity valuations and uncertain underlying fundamentals, it remains a very risky market, and investors would do well to make sure they have an asset allocation that is appropriate for them.

Lyn Alden

A week sure can make a difference.

In last week’s article, I highlighted the fact that the C Fund (which tracks the S&P 500) was pushing up to new all-time highs even as the underlying fundamentals of most of the companies in the index remain rather weak.

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Late last week and into this week, there has been a sizable price dip, especially in some of the big tech stocks that have recently outperformed (and that hold the biggest positions in the fund due to their large market capitalizations).

It remains to be seen if this is just a small correction that will be bought, or if it’s the start of a larger drop. Either way, given the combination of high equity valuations and uncertain underlying fundamentals, it remains a very risky market, and investors would do well to make sure they have an asset allocation that is appropriate for them.

The Apple Anomaly

Apple is currently the largest holding in the C Fund, and its stock price has broken out to new highs this year, literally doubling in price in a matter of months, even though its trend of fundamentals (revenue, earnings, dividends, and so forth) remained relatively unchanged.

This chart shows Apple’s stock price in black, and the stock price it would be at if it traded for its historically average valuation in blue, and the stock price it would be at if it traded at a long-term price/earnings/growth ratio of 1x in orange:

There are many potential reasons for a move like that. For example, interest rates are at all-time record lows, which investors can use to justify higher valuations. In addition, Apple is increasingly focusing on growing services and software revenue from its existing hardware ecosystem, so investors can boost the valuation a bit and re-rate it more like a software company.

However, the scale and speed of this move sure seems concerning, and there is a potentially large cap down if investors re-rate it for a more historically normal valuation. It’s much harder for Apple to produce long-term good returns from this price level than it could when it was half of this price.

News broke over the past week that Softbank, the large Japanese conglomerate that invested in a variety of companies like Uber and WeWork, recently spent several billion dollars buying call options on big U.S. tech stocks. This is rather unusual behavior from such a large firm. In addition, small retail traders have the most aggressively bullish call option position in history.

This represents a lot of bullish speculation in the market. And because options give the buyer quite a bit of leverage, it can move markets more than the investment size would seem, largely due to how market makers have to balance their books. One option contract gives the buyer control over 100 shares, and buying billions of dollars worth of options can effectively move tens of billions worth of share value. Market makers that sell those options need to hedge their positions, so they generally buy the underlying stock while the position is open. This process can drive up a market rather quickly, but it can also correct downward rather quickly if it reverses.

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