Tesla (NASDAQ:TSLA) stock has been on a wild ride upwards this year. Shares soared 50% after the company announced a stock split on Aug. 11, bringing its 2020 gains to an astonishing 370%. As feelings of the 1999 tech bubble re-emerge, short-sellers have asked themselves: is it time to short TSLA stock?
Having witnessed multiple stock booms and busts over the years, I can tell you one thing about bubbles: momentum matters.
Right calls with the wrong timing have wiped out countless investors. Even short sellers of fraudulent companies like Wirecard (OTCMKTS:WCAGY) nursed losses for years before the German payments company finally filed for bankruptcy in June.
So even if you believe the average analyst price target of $1,406 (which suggests a negative 34% downside), there’s still a possibility of getting wiped out first if prices keep surging before they plummet.
Save yourself the heartache. Here are five reasons why Tesla may keep rising before a correction.
1. TSLA Stock: High Prices Cause High Prices
Tesla’s high stock price, paradoxically, makes it even more likely to keep going up. Why? That’s because it makes it cheaper for the company to raise capital.
George Soros termed the phenomenon “reflexivity.” And here’s how it works for a company like Tesla:
During their high growth phase, young companies need capital. And for a car manufacturer like Tesla, lots of it. Conventional car factories can cost over $1 billion to build, and Tesla’s estimates its “Gigafactory” plants in Nevada and Berlin will cost 4-5 times as much.
But where does the money come from?
In Tesla’s case, the company has used shares of its own pricey stock as cheap currency. Shares outstanding have more than doubled since its 2010 IPO as it has issued more and more new equity.
Original TSLA shareholders have faced multiple rounds of dilution from capital raises
With a market capitalization of $375 billion, TSLA can now simply issue 0.6% of its capital base to raise $2.3 billion for investment as it did in the first six months of 2020.
As Tesla’s share prices keep rising, the company can raise even more capital with less dilution, fund even more projects, and increase its share price further. It’s a virtuous cycle when it works.
However, the same flywheel can also run in reverse. If Tesla shares start falling, they can crash hard in a self-reinforcing cycle.
2. Inclusion in the S&P 500
The second reason TSLA might spike has little to do with the company itself.
In July, the company announced an odd little milestone: it had been profitable for four straight quarters.
If this were the startup world, investors might reach for the champagne to celebrate. In the public equity world, however, investors will pick up the phone and call S&P Global Ratings, the parent of the S&P 500 stock index.
That’s because the S&P 500, which doesn’t yet include TSLA, will only add companies with four straight profitable quarters.
And inclusion in the club matters.
Studies show that getting added to the S&P 500 raises stock values 3-4% as mutual funds and index funds rush to buy the newly joined company. And with low-cost index funds dominating today’s investment world, inclusion probably merits an even more significant bump; Carrier Global (NYSE:CARR), which was added to the S&P 500 in April, saw prices skyrocket 27% on the day of inclusion.
While there are no guarantees that Tesla will get added to the S&P 500, its most recent profitable quarter makes it far more likely.
3. Stock Split: Signalling Future Growth
The third reason has to do with analyst expectations during stock splits.
Last week, TSLA announced a 5-for-1 stock split. While splits shouldn’t theoretically change the company’s fundamental value, studies show stock splits do boost share prices. Not only are they more affordable to buy. Analysts tend to see splits as a positive sign.
Following split announcements, analysts typically raise earnings estimates 2.2% – 2.5% and adjust their target prices upward to match.
Even by Elon musk’s standards, splits are a bullish signal. It’s management’s way of saying they’re not afraid of the perception that shares are suddenly worth far less.
There’s a downside, though. These same studies find that the effects are only temporary. After gaining an initial boost, shares tend to underperform the market over the next 12 months as the stock re-rates back down.
4. Markets Signal More Greed
Fourth, markets continue to expect further gains, which would also send Tesla stock higher in the short-term.
It’s a less-than-obvious point – investors have already started to wonder whether we’re in the late innings of a bull market. The economy has suffered its worst recession in decades, yet stock prices are reaching all-time highs.
Three indicators suggest the party’s not yet over.
Firstly, yields on junk bonds are still trending downwards towards its baseline level.
Investors still remain slightly fearful
In ordinary times, investors typically require a 3.4%-3.7% premium to buy high-yield (aka junk) bonds. After peaking at 10.9% in March, the indicator has declined to 5.25% today. That means there’s still room to fall and for institutional investors to return to complacency.
Secondly, the VIX index, a measure of market volatility, is still declining towards its long-term levels. As VIX normalize, stocks typically rise.
Finally, consumer interest in stocks remains high. ETFs gained $206.1 billion in funds in the first half of 2020 (compared to $111.2 billion in 2019), and investors have poured another $10 billion into ETF funds since July.
5. Momentum: the Nifty Fifty Effect
Finally, there’s the Elon Musk factor. Or rather, a tech boom in general.
Since the start of 2020, FAANG stocks and Tesla have outperformed the market many times over as investors have rushed to buy large-cap growth companies.
While many investors compare draw parallels to the 1999 tech bubble, what’s happening is closer to the 1970s Nifty-Fifty bubble. And that means we’re in for a wild ride.
In the late-1960s, Morgan Guaranty Trust identified 50 stocks that represented the fastest-growing high-quality companies in the United States. These companies included 3M (NYSE:MMM), Procter & Gamble (NYSE:PG) and IBM (NYSE:IBM), among many other blue chips of the day.
There was a sense of optimism in the late 60s. These companies could grow forever, money managers reasoned, and so they must be worth a premium.
“The delusion was that these companies were so good,” Forbes Magazine wrote in 1977, “it didn’t matter what you paid for them; their inexorable growth would bail you out.”
By 1972, the Nifty Fifty’s average price-to-earnings ratio had ballooned to 42x, compared to the average S&P 500 stock at 19x. The market peaked in 1973 when Polaroid and Disney (NYSE:DIS) reached P/E ratios of 94.8x and 71.2x.
And then came the crash.
Investors today are seeing something similar in tech stocks. While it’s true that online companies will outperform brick-and-mortars in general, it’s getting harder to rationalize the sky-high valuation ratios of these companies.
What’s TSLA Worth?
“Markets can stay irrational longer than you can stay solvent,” British economist John Maynard Keynes famously quipped.
Today, Tesla trades at a staggering 15 times price-sales (P/S) ratio, or 135 times forward price-earnings (P/E). That makes it as valuable as Toyota (NYSE:TM), Volkswagen (OTCMKTS:VWAGY), Hyundai (OTCMKTS:HYMTF), and GM (NYSE:GM) combined.
Even growth investors might pause before investing; to justify its current stock price, TSLA would have to double its margins and grow 65% annually for the next 8 years. Even Apple (NASDAQ:AAPL) never came close to those numbers.
Yet, even with sky-high valuations today, Tesla shares will probably keep rising in the near-term. Excitement over electric vehicles and fast-growing tech companies means investors will continue ignoring both traditional and VC valuation methods alike.
That will leave investors playing the age-old game of riding a rocketing stock and jumping off before TSLA crashes back to earth. Many will profit by getting out in time, but that doesn’t mean everyone will. Buyers (and short-sellers) beware. TSLA is in for a rough ride.
On the date of publication, Thomas Yeung did not hold a position (either directly or indirectly) in any of the securities or cryptocurrencies mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.