A hedge fund chief who oversees $1.7 billion warns the stock market's 'egregious' valuations being fueled by the flood of government stimulus could see a meltdown later this year — and says inflation will be worse than expected

  • Stocks closed at record highs last week as vaccinations continued. 
  • But hedge fund manager Mark Yusko is worried about steep valuations.
  • He told Insider that a surge in inflation later this year could sink stock prices.
  • See more stories on Insider’s business page.

For now, Mark Yusko likes where the stock market is sitting.

Don’t mistake that to mean he’s bullish on its fundamentals. For the most part, at least, he isn’t.

Rather, it’s simply difficult for the Morgan Creek Capital hedge fund manager, who oversees $1.7 billion in assets, to be bearish in a system flush with cash amid sizable fiscal and monetary stimulus.

But it’s a dangerous road to go down. The high levels of liquidity in markets are inflating stock valuations, he said, and put the market at risk of a steep pullback.

“I think valuations for broad equity markets are egregious — worst that they’ve ever been, worse than 2000,” Yusko told Insider on Wednesday.

“But the self-correction mechanism that has historically existed has been trampled. There are fewer short sellers than there ever used to be. We’ve got more passive money that isn’t allowed to think — it has to buy, no matter what the price. Less active management, less hedging is going to lead to exaggeration of price trends.”

He added: “When the eventual reckoning happens it’s going to be worse than it otherwise would be or has historically been. The problem is timing that is really, really hard.”

While he said that stocks could go higher later this year if more stimulus is pumped into markets and the economy, Yusko holds that stocks will eventually have to return to “fair value,” which is shown by the red trend line in the below chart from Advisor Perspectives. This decline happens if either earnings increase or stock prices drop.

Advisor Perspectives

Yusko said that there’s a chance that the economic recovery is strong and fuels earnings growth so much that valuations compress.

But the more likely scenario, Yusko believes, is grimmer. 

As the economy reopens this summer, Yusko thinks that inflation will spike to higher levels than investors have been anticipating. This will spark a rise in interest rates, which will bring down stock prices most likely sometime in the fall, he said. 

“I absolutely believe that the ratio of price to fair value will get back to normal. They’re not going to stay overvalued forever,” Yusko said. 

“I think we’re much more likely to get some correction,” he continued. “If interest rates rise, that puts a pin in some of these really stupid valuation numbers. And I think the fall we could see some meaningful weakness in equities.”

Yusko said the areas of the market he thinks are overvalued are emerging technology, cloud companies, and “story stocks.” Some specific stocks that fit in this category, he said, are Snowflake, Zoom, and Beyond Meat.

Yusko’s views in context

Yusko is not alone in his worries about inflation. It has in fact become investors’ biggest concern in recent months as consumers get ready to pour money into the economy. 

The Federal Reserve has also said that they would let inflation run above 2% in the coming years to make up for low inflation over the last decade. 

Further, Fed Chairman Jerome Powell has said that the central bank isn’t concerned about a one-time surge in inflation this year.

If inflation runs too hot this summer, it could spook investors and trigger a sell-off. Michael Cuggino, portfolio manager of the Permanent Portfolio Permanent fund (PRPFX), told Insider last month that he’s worried that investors are underappreciating the level of inflation we could see.

“You’ve got two generations of investors that have never really managed around a volatile interest rate environment, and/or an inflationary one. So there’s a little bit of an X-factor in terms of what these investors will do if they’re presented with high volatility in interest rates, and/or inflation data,” Cuggino said. 

“Is it going to be like yelling fire in a movie theatre where all the bond investors struggle to get out the door at the same time because they’re holding longer-duration bonds?” he added.

Valuations are also stretched by a lot of measures, and some of the biggest names in equity research are wary of overextended sectors like tech.

Still, an economic recovery lies ahead. And if earnings outpace estimates, stocks could continue their relentless upward tear. 

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