Are The Foundations Of This Market Looking A Little Ragged?

If you were an investor during the dotcom bubble of 1999 that turned into the dotcom bust of 2000 and then into an extended and painful bear market, then you now what we’re seeing now isn’t a comparable level of distress in the underpinnings of the financial markets.

Which doesn’t means that there isn’t some level of stress showing up in the foundations of the financial markets. Or that you should ignore the signs of that stress.

If you follow the market headlines at all, you’re aware of the struggles of recent market favorites such as Peloton and WeWork to go public. At the least, these struggles are a sign that investors and traders who had bid up the value of these unicorns (the Wall Street moniker for companies that have attained a valuation of $1 billion or more while still private) are rethinking the values they have calculated for these companies. Some examples? Uber, 30% lower the at its May IPO; Left, down 42% since it’s March IPO; and most recently Peloton, which finished its first trading day down 11% (and $923 million) below its IPO price.

The most intriguing, and potentially meaningful example, however is WeWork, the company that decided to pull its IPO. The immediate problem with WeWork was valuation. Venture capital investor Softbank had recently put $1 billion more into the company at a price that sent the valuation for WeWork to $47 billion. But it turned out that when WeWork’s gold-plated investment banking team headed by Goldman Sachs and JPMorgan did their dog and pony shows for potential investors not enough were interested in paying enough per share to bail out Software’s last financing round. And as the investment bankers continued their rounds, the valuation investors were willing to pay for a WeWork IPO continued to fall. Investors were skeptical about paying up for a company that looked more like a real estate venture than a technology company. Speculation about a $15 billion valuation began to circulate. And at that point WeWork and its investment bankers decided to pull the deal.

This might be important to you if all this IPO pain leads to a re-evaluation of the prices of other market favorites that share characteristics with the unicorn IPOs–that is they aren’t profitable (or at barely so) and they trade on multiples of sales instead of earnings. Some, such as Salesforce.com (CRM) even share another quality in that they have a questionable path to growing earnings. If the lessons of these IPOs on valuation spread to the wider market, we’re not looking at anything like the 1999-2000 dotcom bubble, but we are looking to a downward revision in some of the market’s most hefty valuations (price to earnings or price to sales.)

I think it would be sensible to reduce positions in stocks with these characteristics and I plan a sell or two in this vein tomorrow, Tuesday.

On a completely different front, I find myself troubled by the continued odd behavior of the short-term money markets despite the Federal Reserve’s attempts to provide more liquidity to stabilize this end of the financial market.  The Fed has been providing $50 billion to $75 billion a day in overnight financing to this market through action in the repurchase market. (Which makes it possible for banks to use recently purchased Treasury holdings as collateral for short-term borrowing–often to pay for the purchase of those Treasuries.)

The Fed’s intervention was designed to lower rates for overnight borrowing that had popped above 10% and reduce them below the current 1.75% to 2% benchmark Fed Funds rate.

The intervention has worked–by and large–but it’s the exceptions that worry me. Although the quoted repo rate has moved back below the Fed Funds rate, some banks are, according to the Financial Times, paying hundreds of basis points above the Fed Funds rate for their short term money. (Just a reminder, it takes 100 basis points to make up a percentage point.) What this indicates to veterans of the sub-prime mortgage prices and the collapse of Lehman is that a significant number of participants in their market think there might be undisclosed and tough to quantify counterparts risks. Some borrowers in this market, the rate structure seems to suggest, may not be “good” for repaying all their obligations. And no one wants to get caught on the other side of a trade with one of those borrowers.

It was the fear of counterparts risk that froze the financial markets around the Lehman collapse since no one felt they knew where the risk was and no one was willing to lend with that lack of information. Memories of that period are one reason that the Federal Reserve is discussing the formation of a standing facility that would provide a wide range of banks and other institutions with the rapid ability to convert Treasury holdings into cash.

I glad to see that the Fed is studying such as backstop.

I’m not totally comfortable with the fact that the Fed feels that such a backstop might be needed.