Summary:
-QQQ options trade at a substantial pricing discount to the options of its constituent stocks, and are among the cheapest on the market by IV
-Despite the widespread notion that equities in 1999 were the most expensive on record, they traded at comparable or even lower multiples than many popular stocks right now, and were on average much smaller than today’s mega-caps, in terms of market cap and relative to GDP
-Total US market cap is $55T now compared to $17T in 1999, with GDP failing to rise to the same extent. This, combined with a residential real estate market more expensive than its ever been relative to household incomes, makes the wealth effect on the economy extreme as financial assets swing in price
-The recent Fed Beige report published Wednesday indicates a downturn in activity and spending in August, unexpectedly down from moderate growth in July; today’s unemployment report confirms a much slower rate of hiring
-If there is ever a wise moment to hedge, with the current equity market pricing and clear risks, and when the hedge price/odds more than offset the likely total loss of the principal, it’s now
Below is a list of the multiples of 7 popular stocks. 3 are prices from mid 1999, 4 are from this summer. See if you can identify which are which.
They kind of all look the same, right?
1 is Amazon in 1999, 2 is Eli Lilly today, 3 is Cisco in 1999, 4 is Nvidia right now, 5 is Microsoft in 1999, 6 is Broadcom right now, and 7 is Trade Desk right now (upon edit, Trade Desk earned $250m in trailing year net income, so it trades at a P/E of around 197).
Cisco’s PE of 192 stands out, but NVDA might be the most expensive on that list due to the possible/likely mean reversion of earnings and its size. The average P/S of the 1999 stocks is 21, their P/B is 62. The modern four have an average P/S of 27, with a P/B of 47.
Another thing to notice is the average market cap of the 1999 bubble stocks was around $300b, the four modern ones here have an average of $1.2T. They are much bigger now. Back then, Microsoft traded at 5% of US GDP, Cisco was at 4.7%. Right now we have Nvidia at 13% of GDP (using its peak market cap a few weeks ago), Apple at 13% of GDP, Microsoft at 12% of GDP, Google at 7.6% of GDP, Amazon at 7.2%, Meta at 5%, Berkshire at 4%, Eli Lilly at 3.2%, and even Tesla at 2.8% of GDP. Those nine companies are now priced at nearly 70% of GDP collectively.
If you think GDP is irrelevant because these companies generate international sales, think again. US GNP, which includes foreign sales by American companies, is $28.8T vs GDP of $28.65T, it makes no difference.
While the SP 500’s current price to book (5x now versus 5x in 1999) and price to sales (2.9x now versus 2.1x in 1999) match/exceed those of 1999, current extreme sizes and valuations combine to make the US market cap to GDP nearly 40% higher than the 1999 peak. If that group of nine doubled in price they’d trade at 140% of GDP.
Two of my favorite bubble stocks right now are Costco and Fair Isaac (the FICO score company that we all love so much). What’s fun about them is that they’re non-tech, and they’ve become far more expensive than ever before. In 1999 before a lost decade for the stock, Costco traded at 0.6 price to sales, 5x p/b and 43x earnings, it’s now at 1.5x sales and 65x earnings, 16x p/b. Costco is a fund favorite right now as they continue to post impressive profit growth, with consumers flocking to cheaper options as they run out of cash to spend. Like a lot of other people, I’ve become an avid Costco member this year with outrageous prices at many other grocers. In 1999, FICO traded at 2x sales and 17x earnings, it’s now at 28x sales and 98x earnings.
With sales of $1.6b a year, and profits of $450m a year, how do people expect to ever get their $42 billion back buying FICO right now? Even if sales and profits rose 500% overnight, you’d wait 20 years to get back what you paid to own the company. Absent them developing a miraculous AI supercomputer that will become Skynet, the stock is dead money for decades.
If you combine the current total US market cap of $55T and the value of US housing around $45T, you get 3.6x total equity and housing value to GDP. In 2007 this ratio was 3x, and in 1999 it was around 2.8x. Never before has there been so much paper wealth relative to any possible measure.
In the past, housing and stocks moved on their own accord and one could rise while the other fell. In my opinion, those days are long gone, and the two have recently and will continue to move in tandem and be subject to the same buying/selling forces by the same buyers and sellers. It’s all the same now. Stocks, homes and bitcoin have all done the exact same double top motion from 2021 to now, and will likely have a correlation near 1 in the next few years.
That’s why I call this the everything hedge.
Buying options is almost always dumb, for the most part you want to make money selling them when they’re expensive. Nearly 80% of equity options expire worthless and outside of hedging, they’re bought primarily by belligerent gamblers trying to get rich quick.
Of all publicly traded instruments with options, the QQQ index’s options are among the cheapest. Most of the QQQ’s biggest constituents have options chains showing implied volatilities of 45%+ for the deep out of the money puts expiring in a year or two. For the QQQ, as of last week, they trade under 25% IVs.
So despite the fact that nearly every stock in the QQQ has IV pricing above 45%, the QQQ’s options trade at less than half that price. They are much more liquid than the options of individual stocks, and after a generational run up in the index, I imagine it feels like free money for institutions to sell puts on it, which is why the options are historically cheap.
You might remember in 2007 the risk profiles of the CDOs which packaged millions of subprime mortgages up and sold them were estimated to be much lower than each individual mortgage due to a supposed diversification of risk and the idea that only an extreme event would cause them to collectively default and cause investor losses; the yields on these CDOs probably felt like riskless profit for a while. I imagine the QQQ options pricing is based on a similar concept, which is that a large decline in an index fund is extremely rare and would require some historical event slicing the valuation of hundreds of stocks by more than half. Which is definitely the case. But this particular index is the most poorly constructed I’ve ever seen, with one major weakness: 9 stocks comprise half its value, and they are all the biggest ones that I listed above.
My readers know I’ve been incessantly and annoyingly negative about US equity prices since 2017 or so, and I’ve been shouting at the clouds since 2021. But in that time I had never felt the need to place a bet on it, given the extreme risk of doing so, the fact that prices can always rise, the bad options pricing, and the lack of an obvious and immediate danger to markets. That changed this Thursday, when I bought QQQ put options expiring Dec 2026, strike $325, price $13 per put.
To be clear, this is obviously gambling and the chance of total loss is high. I don’t recommend this to anyone, and it’s likely best suited for professionals/funds with large US exposure who are willing to hedge and can take the loss on a small position. This post isn’t a declaration that I feel the bet will hit, or that I’m sure markets will decline, because I’m not at all. I am saying however, that the QQQ options prices aren’t accounting for reality whatsoever, and they aren’t adjusting as quickly as they should be to extreme valuations and the ongoing economic slowdown. At this price, I fully accept the risk of total loss. With the QQQ at $460 when I placed the bet, you can do the math on the payoffs, but it breaks even at a 32% QQQ decline before Dec 2026, and 10x’es with a 60% decline. The $230 strike at $4 per are likely a better bet but riskier, needing sharper declines but having much better payoffs. To also be clear, many of my clients can’t buy them as they don’t have options access, the risk is extreme, and the $13 puts wouldn’t fit in their accounts (to my knowledge, you can’t split them up and each order has 100 puts per, so I’d have to buy the $4’s which is a crazy bet that few would like to make, so as of right now this is just for my personal account). With the current extreme enthusiasm for shares at any price, and the unfettered belief by investors that any dip is a dip worth buying, I imagine this will need every day of those 2 years+ to have a chance to payoff.
The primary reason I bought this week rather than last month or in 2021 is that there is good evidence the economy is sharply deteriorating and people are starting to struggle. Many consumer facing businesses have recently used similar language- see Home Depot, Dollar Tree, Dollar General, Williams Sonoma, Big Five, Nike, McDonalds, Starbucks, Chipotle, etc, most of which are reporting recent sales and profit declines; feel free to pick any 10 random US consumer cyclical stocks and listen to their executive discuss recent consumer spending habits. With corporate profits at record highs, and having taken as much as they could from the average consumer since 2020, it will be much tougher for corporations in the next few years. After the unemployment rise the last 6 months (which has never been followed by a sudden flatline or deceleration), the Fed quietly published its August edition of the Beige Report this week, which might be the best summary of current economic conditions, while the GDP rate lags substantially and is vulnerable to wild inventory swings. Their summary lays it out quite well, and to clarify for the first sentence, there are only 12 Fed districts:
“Overall Economic Activity
Economic activity grew slightly in three Districts, while the number of Districts that reported flat or declining activity rose from five in the prior period to nine in the current period. Employment levels were steady overall, though there were isolated reports that firms filled only necessary positions, reduced hours and shifts, or lowered overall employment levels through attrition. Still, reports of layoffs remained rare. On balance, wage growth was modest, while increases in nonlabor input costs and selling prices ranged from slight to moderate. Consumer spending ticked down in most Districts, having generally held steady during the prior reporting period. Auto sales continued to vary by District, with some noting increases in sales and others reporting slowing sales because of elevated interest rates and high vehicle prices. Manufacturing activity declined in most Districts, and two Districts noted that these declines were part of ongoing contractions in the sector. Residential construction and real estate activity were mixed, though most Districts’ reports indicated softer home sales. Likewise, reports on commercial construction and real estate activity were mixed. District contacts generally expected economic activity to remain stable or to improve somewhat in the coming months, though contacts in three Districts anticipated slight declines.
Labor Markets
Employment levels were generally flat to up slightly in recent weeks. Five Districts saw slight or modest increases in overall headcounts, but a few Districts reported that firms reduced shifts and hours, left advertised positions unfilled, or reduced headcounts through attrition—though accounts of layoffs remained rare. Employers were more selective with their hires and less likely to expand their workforces, citing concerns about demand and an uncertain economic outlook. Accordingly, candidates faced increasing difficulties and longer times to secure a job. As competition for workers has eased and staff turnover has fallen, firms felt less pressure to increase wages and salaries. On balance, wages rose at a modest pace, in line with the slowing trend described in recent reports. Skilled tradespeople and other workers with specialized skills remained in short supply and continued to see stronger wage increases, as did those in unions.”
After reading this summary of labor markets, one would expect flat unemployment for August, but lower payroll growth as consumer spending drops, which will first impact part-time workers before it spills over into full-time employment in the next few months, which is pretty much what Friday’s unemployment report spelled out. The unemployment rate dipped from 4.3% to 4.2% due to people leaving the full-time workforce, and with the clear signal that consumer spending is unlikely to increase with lower hiring numbers.
Obviously there’s a chance that we get the first false-positive unemployment spike in history and the economy continues to chug along, although that feels less likely as the evidence builds up. The clearest risk to this thesis/bet is the likelihood of stock prices simply not responding negatively to current conditions even if a recession does occur in the next year. The dip-buying remains insatiable and even if valuations drop over time as they should, it could be a long and slow process that takes years and years rather than the sharp drops which have occurred in the past. This would benefit US large-cap fund managers who would have years to offload stocks at incredible multiples as negative data piles up and corporate profits decline, but does little for me with this bet or in finding cheap American shares to buy. 2021 until now is the longest stretch of equity valuations this high ever before (in the past they only briefly reached this point before sharply dropping), so clearly a very, very obvious and extreme catalyst is needed for real selling to occur and for stock prices to move towards normal valuations. As of right now, I don’t think anybody believes it’s possible for them to be lower in a decade.
So while it’s my potentially biased opinion that we’re looking at a clear risk in our faces, I wouldn’t predict or declare that stocks will decline anytime soon, because I obviously have no idea what they’ll do. If these options were double the current price, the bet wouldn’t be worthwhile. This is similar to how I invest- nobody knows with certainty what our portfolio companies will do, I just try to buy at great prices. This post is just a statement that the options prices are good enough to warrant risk on the possible outcome given developing data, as well as the fact that extreme price declines in stocks have only ever come after they reached extreme prices.
Edit: It’s clear this particular market will allow for more certainty than ever before regarding the speed of economic / earnings slowdown before adjusting prices. While everything is slowing down, nobody knows yet whether it’ll lead to recession or simply slower growth. With NVIDIA’s price nearing 70% of Japanese GDP after a quarter in which their QoQ metrics decelerated, it’ll take legitimate sales declines before the price stops rising. Before taking risk on a hedge, one might be able to wait until unemployment rises above 5%, and/or until NVDAs sales and profits are outright dropping, and receive a similar options price to what I paid, if not substantially better. Regardless, I think it’s a suitable hedge for those heavily invested in American assets.