17 Sep Why it’s sometimes unwise to be fashionably late
Since the start of the COVID crisis, our aim has been to communicate our view on financial markets weekly before reverting to fortnightly in April but this latest edition, for a number of reasons, is a week late. We apologise for this, but will ensure we keep to the bi-weekly frequency from now.
In this bulletin we look at the technology sector and why recent share price weakness might not spell disaster in the same way as the tech bubble of 2000.
Why it’s sometimes unwise to be fashionably late
There have been many noticeable things about 2020 so far, but one of them is the performance of US stocks and more precisely that of the technology sector. Those investors of a certain age and with reasonably long memories might remember the 1990s as being a period when technology stocks were all the rage. The theme was labelled TMT (technology, media and telecoms) and this brought with it the emergence of the ‘day-trader’, private investors giving up their jobs to trade (mostly tech) stocks. It did not end well.
Since markets fell in February and March this year, it has once again been technology stocks that have made most of the running. Consider this. Since the end of March, when equity markets bottomed-out, the UK FTSE-100 has risen 20%, which represents a pretty good recovery, given the disruption caused by COVID. China has managed slightly better at 25%, but the US S&P500 index dwarfs this with a bounce of 64%. The tech-heavy Nasdaq index has done even better, rising almost 80% from trough to peak, which is a quite extraordinary rebound in only six months.
Whilst twenty years ago we talked in terms of TMT stocks, the terminology is now different. We use the acronym FAANG (Facebook, Apple, Amazon, Netflix, Google) but the theme is uncannily similar. So, with prices having stepped back from their highs (see chart below), the question is whether this represents a healthy ‘pause for breath’ or the start of a more profound reversal, akin to the one we witnessed at the turn of the century, which incidentally wiped out many day-traders.
As the title of this article suggests, when a bubble emerges within financial assets, it is the last to join that get punished most severely when prices go into reverse. Sadly, evidence suggests this is nearly always retail (private) investors. So are private investors destined to get their fingers badly burned once again? Well it is true that the numbers of private individuals opening share trading accounts is at record levels, but so too is the number of people taking up golf, meaning it could simply be a consequence having a bit more time on our hands and the desire to fill that time with something productive.
So to answer the question we need to look at the landscape in 2000 and make a comparison with where we find ourselves now. The first and most striking difference is that technology companies back then, despite their share prices being in overdrive, did not make any money. The internet was in its infancy and one metric investors looked at was the ‘burn-rate’. In other words, the amount of time a firm could survive before it depleted its cash reserves to zero, the hope being profits would come before this ‘event horizon’, hardly a sound thesis for making an investment. There is a saying in markets that stocks follow profits in the long run. The trouble is in the late 90s, almost none made any.
After the 2000 crash, a few names, such as Ebay, Amazon and LastMinute survived but most didn’t. The role-call of casualties is lengthy – Pixelon, Excite, 360Network, Kozma, Worldcom and Global Crossing to name a few, went bust. Infospace survived but the share price fell from $1300 in 2000 to $2.70 a year later.
Contrast this with the FAANG stocks now. Between 2011 and 2019, Amazon increased revenues by 483%, Netflix by 529%. One of the newer kids on the block which everyone will know from a COVID world, Zoom, enjoys a profit margin of 40% and is growing revenues at 70% per annum. Contrast this with Sainsburys, a very well-run company, but which operates on a 7% margin, growing at 4%pa. The bottom line is that today’s technology companies are growing revenues, making profits and accumulating cash at a rate their predecessors could only dream of.
If the adage of stock prices following profits is true, and we firmly believe it is, then investors are perfectly justified in buying these ‘new economy’ stocks. True, some have risen too far too fast, but the FAANG stocks just happen to be extremely well-run companies with strong balance sheets. But here is the scary part. The top 5 US companies, all of which are technology related have added $5trn to the value of the S&P500 index over the last 5 years. The other 495 companies which comprise the index have contributed less than $4trn between them. Moreover Amazon, Apple, Microsoft and Alphabet (Google) have a market capitalisation which is greater than the whole of the Japanese stock market. This presents two issues for investors. The first is that buying an investment which mirrors the US stock market will mean that almost a quarter of one’s investment will find its way into just a few technology names. In other words, it is very concentrated.
The other problem is the impact a fall in technology stocks can have on the wider market. A recent example is the recent blip in Apple shares at the start of September. In one day, the fall in the price was large enough to wipe £200bn of value from the company. This is about the same size as the entire market value of Intel (once itself the world’s largest company). The US regulator is not surprisingly very uncomfortable with this and Joe Biden has made no secret of his desire to tackle this level of concentration.
Should all this be enough to put investors off joining the party at all? Well the answer to this is ‘not necessarily’. Potential buyers should naturally be wary of any investment that has risen 80% in six months and the tech-heavy Nasdaq index should be considered in this light. The influence of technology stocks on the wider market now, is redolent of what we saw at the turn of the century, but these companies are extremely profitable and are more financially sound than their ancestors.
Finally, it is worth remembering the economic landscape was materially different in 1999-2000 and this has important implications for the stability of financial assets. In 2000 the economy was ‘running hot’ meaning interest rates were on the rise. Now, the economy is crawling out of a very dark place and there is absolutely no sign of increased interest rates, quite possibly for a number of years.
Pulling all this together, the meteoric rise of technology stocks might seem awfully familiar and this might make investors nervous, especially when that growth path gets halted as we have seen this month. But the FAANG stocks of today are a million miles apart from the rag-bag of internet hopefuls being chased by investors 20 years ago. Every crisis creates winners and losers. COVID has unquestionably changed the way the world works and this has helped technology companies, but this has merely accelerated an already established trend. One day, there will be reversal in the FAANG stock prices, but we don’t think this is just yet. Not a reason to join the party, but equally probably not time to call a cab home.
Dr Andrew Mann