Weekly Reads - June 26, 2023
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Momentum in the AI and the tech sector has reached its boiling point with mass retail investors following institutional money in the tech/AI sector inflating sector valuations as the U.S. heads toward an economic downturn.
Retail investors are getting caught up in the recent S&P 500 rally buying $1.5 billion of single stocks last week, an all-time high. Most of the inflow went into just three names: Tesla, Apple, and NVIDIA. Those three stocks have accounted for 43% of the S&P 500 gains this year. With AI hype in full force, retail investors are riding the momentum wave in these stocks hoping to benefit from the rally in the tech sector. With most of the S&P 500 gains this year coming from a handful of names alongside daily headlines about the promise of AI, it’s no mystery why retail investors are seeking exposure to this specific sector. The question remains how long can this rally continue and when will professional investors begin pocketing profits leaving retail investors holding the bag? Recent data might be indicating that this rally might be running out of fuel. The 36% rally in the Nasdaq 100 Index pushed the index to trade 24% above its 200-day moving average, a gap seen less than 4% of the time. The last time this reading was this high was 2020 which saw the index decline 13% over the next month. This reading is also similar to the levels seen during the dot-com boom in 2000 which has many parallels to today.
M&A is often viewed as a quality form of capital allocation, yet it often delivers subpar returns and destroys shareholder value.
Lululemon’s $500 million acquisition of connected fitness company Mirror in 2020 was met with a lot of fanfare amid the at-home-fitness boom during the pandemic. Just three years later the company is admitting failure and is looking to offload the company for a massive discount. Lululemon now values Mirror at just $57 million, a staggering 88% discount on the acquisition price. Despite this discount, Lululemon is finding it difficult to find buyers for Mirror. During the pandemic, Mirror was showing positive signs, but by the end of 2021, the company lowered expectations as consumer interest in at-home fitness vanished. Like Peloton, Mirror benefited from the lockdown of fitness consumers during the pandemic, but after gyms were reopened these expensive machines saw less use over time dampening any interest in buying more products. Lululemon is now pivoting to a fully digitally connected fitness strategy through Lululemon Studio, a $12.99 per month digital app offering various fitness classes to subscribers. The failure of Mirror is another example of how M&A more often destroys shareholder value with management overpaying based on forecasts and trends with no historical basis. Even a company with a successful track record like Lululemon can fail in forecasting the next “trend” and allocate capital to projects with low or negative returns for shareholders. While the failure of Mirror won’t impact Lululemon long-term it’s a powerful reminder that for every successful acquisition, there are just as many failures that often don’t make headlines.
The era of cheap capital is ending with many of the companies who accessed this free capital close to defaulting as the cost of debt skyrockets and lenders close their pocketbooks.
The Federal Reserve's plan to keep hiking interest rates will continue to have an adverse impact on corporate default rates in the short term. The corporate default rate rose in May as companies are struggling with higher interest rates that is making it difficult to refinance debt. So far this year there has been 41 defaults in the U.S. the most in any region globally and double during the same period in 2022. In prior years many U.S. companies had access to cheap capital allowing them to lever themselves to fund ambitious projects. The era of cheap capital is over with the cost of debt skyrocketing and previously levered companies having to restructure or file for bankruptcy. Through June there were 324 bankruptcy filings and 230 bankruptcy filings through April, the highest rate since 2010. These numbers could be understating the dire situation many companies are in. The default rate is typically a lagging indicator of distress with many defaults not occurring until other initiatives are implemented to address the balance sheet. Moody’s expects the global default rate to rise above 5% by April 2024, higher than the long-term average of 4.1%. These forecasts could get worse if the U.S. enters a prolonged recession or consumer demand weakens putting more pressure on cyclical companies.