Valuation Compression is Driving the Selloff

valuation compression

Momentum is red… Cash is your best friend. I feel like I’m beating a drum here. On Monday, we saw the S&P 500 Volatility Index (VIX) run to 35. 

If we move to 40, we will likely see capitulation. That means that institutions and retail investors will dump stocks… just to dump them. They’ll throw in the towel and walk away. And at that point, who knows where the bottom is. It’s a good thing I am such a fan of cash. So, now what?

Valuation Compression

Today, I watched CNBC from opening bell to close. This was one of the first days where reality seemed to set back in for the journalists. There were bearish traders talking about capitulation. 

There were momentum traders who said that they went to cash on January 13 and April 5 (that sounds familiar, huh?). Then, they asked a question that stunned me. Their Twitter question reads as follows: “What is driving the selloff?”

  1. The Fed
  2. Earnings
  3. China
  4. Other

Technically, the answer is “The Fed”. But the real answer is Valuation Compression (“Other”). 

Stocks that were trading at outrageous valuations have come down significantly and still have a long way to go. We could also say “Greed” because it was greed that fueled the asset bubble in equities that is now deflating. 

Examples of Valuation Compression

Case in point, look at Sweetgreen (SG), a company that owns and operates fast casual restaurants that make salads. It’s basically, Chipotle, but for salad. Shares fell 14.5% on Monday despite a 67% increase in quarterly sales. What gives?

Well, just a few weeks ago, this was a company that makes salads trading at a price-to-sales ratio of 12. Today, it’s trading at a PS of 6x. And even that might be too expensive. 

You see, companies that have been trading north of 10 times sales are getting crushed right now. CrowdStrike (CRWD) fell 12.9% today (and still trades at 22x sales).

Rivian Automotive (RIVN) dropped 20% today after its IPO lockup period. This incredibly unprofitable company trades at 325 times sales. Bill.com (BILL) (at 24.7x sales) dropped another 10.1% on Monday. 

This is the story of the market right now. Rising interest rates (the 10-year bond in particular) is blowing up the market’s two-year period where fundamentals didn’t matter. There is still a long way to go. Cash remains your best friend. 

Is Tesla Next?

Elon Musk’s Tesla Inc. (TSLA) is still trading at 14.7x sales, and remains one of the last crowded trades at the institutional level. This is the only one of Cathie Wood’s positions that hasn’t fully imploded. But in a negative momentum market – Tesla has been a major source of gains over the last two years. 

I think the next stop of Tesla is $760, followed by a move to 2022 lows of $700. Remember, this happens if momentum remains negative, and investors keep throwing in the towel. If Tesla drops under $695, there isn’t much of a bottom left. There are multiple hedge funds who are hoping and praying that Tesla can maintain support. 

I wouldn’t be surprised if we see it go lower. So goes Tesla, so goes the ARK Innovation Fund (ARKK). My latest price target for Cathie Wood’s fund is $36.50. From there, it’s $31. Then, who knows. It all depends on momentum.

We might get to both levels by Friday, May 20, when options expiration occurs. Stay liquid. Remain patient. Stay engaged. This next leg down is just getting started.

Garrett Baldwin
Garrett Baldwin
Garrett Baldwin joined Godesburg Financial Publishing as Chief U.S. Markets Analyst in early 2021. A Johns Hopkins-trained Economist, he’s worked with hedge funds, venture capital firms, angel investors, and economic advisors to the U.S. government. Baldwin specializes in market anomalies and alternative investments. He’s written extensively on momentum, value, insider buying, and other unique strategies that provide investors that elusive edge.
Garrett Baldwin
Garrett Baldwin
Garrett Baldwin joined Godesburg Financial Publishing as Chief U.S. Markets Analyst in early 2021. A Johns Hopkins-trained Economist, he’s worked with hedge funds, venture capital firms, angel investors, and economic advisors to the U.S. government. Baldwin specializes in market anomalies and alternative investments. He’s written extensively on momentum, value, insider buying, and other unique strategies that provide investors that elusive edge.

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