New World A-Comin'

[jbsliverer]

One view of the market.

https://seekingalpha.com/article/4473297-the-epic-2021-bubble-already-collapsed-we-just-entered-phase-2
The Epic 2021 Bubble Already Collapsed, We Just Entered Phase 2
Summary
Investors are scratching their heads about what's happening in the stock market. While indices keep trading at all-time highs, many individual stocks are crashing heavily.
Here's the explanation: The epic 2021 bubble, which I have been warning for several times, already collapsed many months ago.
However, due to the very specific characteristics of a bubble collapse, the indices continued rallying and are likely to continue doing so for the coming months.
In this article, I explain that we recently entered phase 2 of the bubble collapse and that phase 3 is likely to start in 2022.
How should you approach this very challenging stock market environment? I provide three valuable tips at the end of the article.
Looking for a helping hand in the market? Members of Insider Opportunities get exclusive ideas and guidance to navigate any climate. Learn More »
Bubble
Petrovich9/iStock via Getty Images

The major S&P 500 (SPY) and Nasdaq Composite (QQQ) indices are up over 20% year-to-date and trading near their all-time highs. 2021 has been a very strong year for "the stock market."

In contrast, there are dozens of stocks, especially in the small cap space, which are down 20%, 50% or even 80% from their yearly highs. "The market of stocks" has clearly been much more challenging in 2021.

Many investors are scratching their heads on what's happening with equities these days. How can such significant divergences between individual stock returns exist? Will this trend continue in 2022?

Investors who have been following my articles know that I have a clear theory for this phenomenon: The 2021 bubble. What we experienced in 2021 so far was the first phase of the collapse of this bubble. But there is more to come...

I believe that the recent downturn can be categorized as the second phase of the bubble collapse. Finally, I expect the last phase of the bubble collapse, phase 3, to occur in 2022. Indices will likely continue soaring until this final phase kicks off.

What exactly are these three phases and how should you position your portfolio with a further collapse of the bubble ahead of us? That's what I will discuss in this article. But before doing so, let's quickly recap how this bubble has been formed.

The Cause of The 2021 Financial Bubble
One word: COVID-19.

While markets have already been running hot prior to 2020, ironically it has primarily been the global health crisis which caused the bubble.

The pandemic has led to several events that inflated the bubble:

The Fed printed $4.5 trillion and decreased interest rates to zero. By implementing these stimuli, it was aiming to combat record unemployment rates of 14.8% and recover the economic damage. This unprecedented amount of stimuli caused a major disruption in asset prices and increased the risk appetite of investors. Why would you not take risks if you have a powerful central bank to back you up with free money if things turn south?
As the global lockdown forced us to stay at home, many new people started investing. This new wave of investors primarily consisted of millennials who had no regard for valuations and loved taking high amounts of risks. On top of that, brokers like Robinhood did everything to win these new customers by easing their policies regarding high-risk practices such as buying with margin debt and playing with options.
The pandemic let to an acceleration of technological developments. As such, disruptive tech stocks became more attractive than ever given their soaring growth rates. Many investors believed these high growth rates would persist for many years. As such, these tech stocks were seen as great buying opportunities even when they were trading at extremely expensive valuations.
These three drivers were so strong that it led to a new paradigm of investing: Risk-averse strategies like Warren Buffett's were buried in the ground, while risk-taking strategies like Cathie Wood's were endorsed. Those who didn't follow the latter would be left behind with significant underperformance, almost every investor said.

Phase 1 Of the 2021 Bubble Collapse: Hyped Small Caps (February 2021)
I was becoming suspicious of the start of a stock market bubble when the S&P 500 reached pre-COVID highs and many hype stocks experienced massive gains in the summer of 2020.

It was eventually my analysis of the IPO market in December 2020, "2020 IPO Bubble Just Reached Dot-Com Levels," which made me confident in calling this a bubble. In this article, I explicitly warned investors about the risks with following overvalued hype stocks, but also suggested to stay invested in other (value) equities:

Following the herd by buying hyped stocks can be a very costly mistake which I strongly discourage investors to do.

However, selling out of all your stocks or going full short on the market is another mistake which can be as bad or even worse than the first one!

At our investment community Insider Opportunities we put our money where our mouth was, buying many undiscovered value stocks at great prices instead of following the hype.

For another month or two, the so-called "Cathie Wood investors," "TikTok investors" or "new normal investors" had their fun with investing in extremely expensive hype stocks. However, in February 2021 things changed drastically for hyped small caps with excessive EV/revenues multiples (or even zero revenues):

Company Return since 2021 peak EV/revenues ratio at peak
ARK Innovation ETF (ARKK) -37% NA
Virgin Galactic Holdings (SPCE) -74% No revenues
Plug Power (PLUG) -49% No revenues
Palantir Technologies (PLTR) -50% 56x
Fastly Inc (FSLY) -55% 45x
Skillz Inc (SKLZ) -80% 69x
Lemonade (LMND) -74% 105x
AMC Entertainment Holdings (AMC) -51% 75x
C3.ai Inc (AI) -83% 88x
Fiverr (FVRR) -59% 60x
Calling the sell-off of these unprofitable, expensively valued, hyped stocks was not just a wild guess. It's a common phenomenon in financial bubbles that the weakest chains collapse much earlier than the rest of the market.

For example, this was exactly what happened during the dot com bubble. Many unprofitable, hyped small caps back then collapsed in 1999, while it took until March 2000 for the general Nasdaq Index to peak. Some examples include online groceries company Webvan (peak at December 1999), consumer health care company drkoop.com (peak at July 1999) and online toys seller Etoys.com (peak at September 1999).

These stocks more than halved before the Nasdaq Index peaked and eventually went out of business a couple of years later. I would not be surprised if some of the companies listed in the table above would declare bankruptcy in the coming years as well.

Phase 2 of The 2021 Bubble Collapse: Overvalued Mid Caps (November 2021)
Over the course of 2021 investors sold off overhyped small caps and searched for other investments to grow wealth in the market. Strongly growing mid cap tech stocks came into the picture as they provided similar potential with lower risks.

The amount of money that flew into these stocks was so significant that many of them gained hundreds of percentages over the course of 2021 in addition to an already strong 2020.

As a consequence of valuations having grown to unsustainable levels, these investments became extremely risky as well. As valuation risks became unbearable and macro-economic challenges increased, this asset class started to sell off significantly in November.

As shown in the table below, many mid-cap growth stocks are down double digits over the past two weeks, with some even losing as much as 50%:

Company Return since Nov. 15 2021 EV/revenues ratio at Nov. 15
CrowdStrike (CRWD) -22% 50x
Cloudflare (NET) -24% 112x
Asana (ASAN) -51% 84x
Upstart (UPST) -25% 31x
DocuSign (DOCU) -47% 29x
Bill.com (BILL) -28% 105x
Roku Inc (ROKU) -27% 14x
Unity Software (U) -27% 55x
DoorDash (DASH) -36% 17x
Sprout Social (SPT) -25% 39x
We believe that November 2021 might have been the start of the second phase of the bubble collapse, the phase where overvalued mid-caps plunge.

Again, history has proven that such high-quality but overvalued mid caps tend to sell off before the market indices do. Amazon (AMZN) and Intuit (INTU) are two great examples which belonged to this category during the dot com bubble. They peaked four months prior to the Nasdaq.

Chart
Data by YCharts
Note that it took these stocks respectively 10 and eight years to recover to their dot com highs despite the fact that the underlying fundamentals have been stellar.

There are growth investors who say valuations don't matter. I respectfully disagree.

While some of the stocks listed above might turn out to become stellar investments for the coming 20 years, investors need to be aware of the possibility that they will crash in the coming months and will need many years to recover to today's levels.

Phase 3 of The 2021 Bubble Collapse: Overvalued Large Caps and Indices (Spring 2022?)
If you read my article "QQQ: Be Prepared For The Biggest Tech Rally In Your Lifetime," you might think I'm crazy. First I'm predicting a huge rally for the Nasdaq and three weeks after I explain why the tech bubble will continue to collapse.

Well, let me explain this discrepancy. The top 10 holdings (out of a total of 100) represent 57.7% of the total Nasdaq Index. Therefore, the QQQ almost solely reflects the price movements of these big tech stocks.

Despite the general turmoil in financial markets over the past months, big tech stocks have stayed remarkably steady, even during the sharp tech sell-off in November:

Chart

Many investors see big tech stocks as the new safe haven. Indeed, their stocks face very low volatility, they have robust balance sheets, generate impressive operating margins (25.9% average) and grow consistently (20.8% average).

Given their strong fundamentals, these stocks deserve a higher P/E multiple. On average, the top 10 big tech stocks trade at a 79.1x P/E and if we leave out outlier Tesla they trade at a 48.9x P/E ratio.

Company QQQ weight P/E ratio Revenue 3-year CAGR 2018-2021 3-year PEG Operating margin
Apple Inc (AAPL) 11.87% 29.1x 11.3% 2.58x 29.8%
Microsoft (MSFT) 10.81% 36.9x 15.1% 2.44x 42.1%
Alphabet Inc. (GOOG) 7.65% 27.7x 20.5% 1.35x 30.3%
Amazon.com Inc. (AMZN) 7.60% 67.2x 25.3% 2.66x 6.2%
Tesla Inc. (TSLA) 5.92% 351x 29.7% 11.82x 9.8%
NVIDIA Corp. (NVDA) 5.21% 99x 27.5% 3.60x 35.5%
Meta Platforms Inc. (FB) 3.23% 22.1x 26.2% 0.84x 41.8%
Adobe Inc. (ADBE) 2.08% 55.6x 18.7% 2.97x 36.5%
Netflix Inc. (NFLX) 1.81% 55.5x 21.9% 2.53x 22.8%
Costco Wholesale (COST) 1.55% 46.6x 11.4% 4.09x 3.7%
Average 79.1x 20.8% 3.49x 25.9%
It is time for me to correct a common misunderstanding about the dot com bubble. Many people believe that today is totally different with 2000 because two decades ago, companies were much less profitable than today. Well, that's wrong.

As you can see in my table below, the top 10 Nasdaq companies of 2000 generated an average operating profit margin of 25.5% (excl. Worldcom). Indeed, the tech leaders of 2000 were cash flow machines as much as the tech leaders are today.

One might even argue that the tech leaders of 2000 were fundamentally stronger companies than today, given that their growth rates were much higher (48.8% vs 20.8%).

Yes, P/E valuations are not that extreme right now. Interestingly though, the average PEG ratio of today (3.49x) is creeping very close to the dot com number (5.03x).

Company Market cap P/E ratio Revenue 3-year CAGR 1997-2000 3-year PEG Operating margin
Microsoft (MSFT) $713 bln 63x 24.4% 2.58x 47.6%
Cisco Systems Inc (CSCO) $633 bln 162x 42.8% 3.78x 17.1%
Intel Corp (INTC) $545 bln 52x 10.3% 5.04x 30.8%
Oracle Corp (ORCL) $313 bln 333x 15.0% 22.2x 30.4%
Sun Microsystems Technology Inc $200 bln 118x 22.3% 5.29x 15.7%
Worldcom Group $180 bln 35x 71.6% 0.49x -110.0%
Dell (DELL) $178 bln 75x 48.0% 1.56x 9.0%
Qualcomm Inc (QCOM) $131 bln 177x 69.1% 2.56x 22.6%
Yahoo Inc $127 bln 648x 150.6% 4.30x 26.8%
Applied Materials Technology (AMAT) $101 bln 76x 30.4% 2.50x 29.2%
Average 173.9x 48.8% 5.03x 25.5%
Big tech companies in 2000 were seen as safe haven as well. Later, investors discovered that these companies were not as indestructible as they believed and that prior growth rates were unsustainable. Astonishingly, the three-year revenue CAGR between 1997 and 2000 of 48.8% reversed to -2.2% during the 2000-2003 timeframe.

Investors need to be aware that the recent big tech growth rates are highly unsustainable. They benefited strongly from the pandemic and central bank stimuli. As these two tailwinds are easing in the coming quarters, we need to be prepared for a possible reversal to single-digit or even negative growth rates for big tech stocks soon.

As explained in my prior QQQ article, I believe money can keep rotating toward big tech stocks in the coming months, leading to a last extreme market rally. However, this is likely to stop when investors begin realizing that they need to factor in much lower growth rates in their valuation models.

I believe that the downturn of big tech and indices, phase 3, will start during spring of 2022.

How To Invest During This Bubble Collapse
At Insider Opportunities, we continue doing what we are good at: Investing in significantly undervalued stocks. By following the personal purchases of insiders, the leaders of the firm who know better than anyone else when their stock is undervalued compared to its growth perspectives, we are increasingly confident that our investments will generate strong mid-to-long term returns.

In 2021, insiders have been buying heavily into small-cap value names who have underperformed as money rotate away from them into big tech. This asset class is currently reaching P/E ratios (14x) not seen since 2011. We believe that picking the right stocks out of them will generate solid returns in each market environment, even when the bubble collapses further.

For example, instead of following the herd into the high-risk fund ARKK, in March we started a significant position in the defensive asset manager Diamond Hill Group. This undiscovered stock with great fundamentals was trading at a 12x P/E and had 20% of its market cap in cash. This investment generated us 42% returns to date.

Over the past weeks, we're experiencing a new pattern among insiders. The smart money is increasingly buying stocks of growth stocks that were sold off heavily during this bubble collapse. As such, we are also cautiously allocating more money to unjustifiably sold off growth stocks. However, as we might achieve a further deterioration of this sector, it's important to be highly selective with growth stocks. Only pick out those with great balance sheets and an attractive valuation compared to growth perspectives. I will write a separate article soon about three very attractive growth stocks.

Lastly, we suggest to have enough cash (10-20%) or cash-equivalent investments (defensive stocks, bonds, etc.) available to benefit from more opportunities in the coming months.

Investor takeaway
Stock market movements have been highly disturbing in 2021: Indices continue reaching new all-time highs while tons of individual stocks went down drastically.

Understanding the three phases of a bubble collapse can give you an edge over other investors to better read this market:

Phase 1 - Hyped small caps collapse: The weakest chains of the bubble always collapse first. That's why you saw no-revenue hype stocks like SPCE or extremely overvalued small cap growth stocks like SKLZ getting slaughtered since February 2021. Most of these stocks will never recover to the peak levels they traded at last year.
Phase 2 - Overvalued mid caps collapse: Mid-cap growth stocks' valuation multiples expanded to unsustainable levels as money rotated into them. These are oftentimes much stronger businesses, but that does not justify 30-100x EV/sales ratios. It looks like November 2021 was the start of their collapse to more appropriate valuations. It will take many years for these stocks to recover to their 2021 peaks. However, some still have the ability to generate strong returns for the very long term.
Phase 3 - Overvalued large caps and indices: Big tech is attracting lots of investors as they are seen as the new safe havens. Investors are forgetting that even big tech stocks are not indestructible and might face negative growth rates soon. Once they realize this, valuations will need to come down substantially and will bring down stock market indices with them.
How should you approach the market going forward?

Continue investing in high-quality value stocks which have the ability to generate solid returns in each market environment.
Increasingly allocate money to unjustifiably sold off growth stocks. However, do it carefully and give more attention to valuations.
Keep a solid cash position or cash-equivalents available to capture more opportunities in the coming months.