Navigating the Shoals of an Overvalued Market

Stocks have struggled to rally in recent weeks, but that hasn't stopped the IPO market from offering investors the chance to leave reason behind.

Last week, two particular deals demonstrated that while the overall market is expensive, pockets of it are undeniably in a bubble.

Here's what you should know about the IPOs and the week...

Be Wary of These High-Profile IPOs

On Thursday, June 11, Axovant Sciences Ltd. (NYSE: AXON) sold the biggest biotech IPO in at least 20 years, selling 21 million shares at $15 per share to raise $315 million. The shares immediately doubled in price to close at $30 per share, giving the company a market value of nearly $3 billion.

The company, which is six months old, was formed when 29-year old Vivek Ramaswamy purchased an Alzheimer's drug from GlaxoSmithKline plc (ADR) (NYSE: GSK) in late 2014 for $5 million. Glaxo shelved the drug years ago after conducting 13 clinical trials.

The company does not yet have any revenues nor does it have an approved drug that it can sell; on the bright side, it has all of seven employees, two of which are Mr. Ramaswamy's mother and brother. After thinking about it overnight, investors dumped the stock on Friday and AXON closed down 25% at $22.31 per share to end the week.

The next day, Friday, June 12, Wingstop Inc (NASDAQ: WING) prices its IPO at $19 per share and saw its stock soar to a first day closing price of $30.59 per share, up 61% and a market capitalization of $875 million. Wingstop has 726 franchised locations (45 international) and 19 company-owned stores. This is part of the restaurant stock bubble led by Shake Shack Inc (NYSE: SHAK), which is trading at a market capitalization of $2.7 billion after tripling since its IPO in February, and Chipolte Mexican Grill, Inc. (NYSE: CMG), whose stock is down to $609.76 per share after hitting $692.52 per share in April (it is still trading at a rich multiple of 40x earnings).

By the Numbers

Despite this IPO mania and a rousing rally on Wednesday, stocks managed only meager gains on the week. The Dow Jones Industrial Average rose 49 points or 0.3% to 17,898.14 while the S&P 500 added just a single point to end the week at 2,094.11. The Nasdaq Composite Index fell by 17 points or 0.3% to 5,051.10.

The yield on the benchmark 10-year Treasury bond traded higher intraday during the week but ended basically unchanged at 2.38%, maintaining its highest levels in several months.

In Europe, German 10-year bunds closed the week at 0.83% after trading above 1% for the first time in months as upward pressure continued on European bond rates. The Euro strengthened to $1.127 as well, which means that the ECB's efforts to weaken the European currency and lower European interest rates are both failing for the moment. As the poet Robert Burns warned us:  "The best laid plans of mice and men oft go awry/And leave us nothing but grief and pain for promised joy."

Markets appear to be convincing themselves that the Fed is more likely than not to be preparing to raise interest rates in September. The Fed meets this week but is unlikely to provide much insight into its plans other than to maintain that its policy will remain "data dependent."

The problem with that statement, however, is that the inflation data the Fed tends to rely on has little relationship to the real world. While official inflation data points to a lack of rising costs, the price of the products that consumers actually use continue to rise while the prices of financial assets are exploding (stocks, art and other collectibles, high end real estate). In other words, policy may be "data dependent" but they are depending on the wrong data!

But as long as they are hell-bent on doing so, they are unlikely to change course and start raising rates until September.

The $200 Trillion Question

The $200 trillion question - $200 trillion being the amount of debt that currently exists in the world according to the McKinsey Global Institute - is this. When the Fed does start raising rates is how financial markets react?

For the moment, I continue to believe that long-term interest rates will fall rather than rise because both U.S. and global economic growth continue to face headwinds.

While the short-end of the yield curve will increase, the long end will likely drop - meaning the yield curve will flatten as a reflection of slowing economic growth. This will likely lead to the Fed moving very skittishly to raise rates, meaning at best there will be one more interest rate hike in 2015 (in December) as the Fed carefully monitors the reaction of both markets and the economy to its actions.

As this happens, stock market investors, who have seen the overall market basically do nothing for the last seven months, will have to decide whether to take more risk or start cutting back their bets.

In an already overvalued market, investors would do well to do the latter before they become part of a crowd trying to rush out of a crowded theater.

About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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