The stock market has been very rational in rewarding the winners (tech, healthcare) and pounding the losers (energy, banks). But has this gone too far? As has been frequently pointed out, Facebook, Apple, Amazon, Microsoft and Google now account for 25% of the composition of the S&P500 index and are up by third en bloc for the year compared to an average fall of 5% for the other 495 companies in S&P500. Nevertheless, tech stocks had a rocky September with suggestions that maybe bust is following boom. It has been well documented that the market cap of Apple is now greater than that of every company in the FTSE100 combined, surely this can’t be right, a bell sounding at the top?
The massive tech companies have created virtuous circles that will bring strong profit growth for many years ahead. They were already growing much faster than the large companies of the past, and this growth is likely to prove less cyclical, because with ‘intellectual property’ as their main raw material, they can grow without much additional capital and have net cash, not debt, on their balance sheets. The pandemic has accelerated this process with much more economic activity and entertainment moving online. These companies have scale and technological advantage, maintaining dominance by buying any competitors to their world, Facebook acquiring WhatsApp and Instagram for example. The greatest risk to their continued growth and dominance, and not a risk to be underestimated, is government anti-trust regulation to curtail their near monopolies and supposed abuse of their powers. The questioning of the cyber barons on Capitol Hill in July was particularly adversarial.
That the tech companies are returning share price growth well in excess of their earnings growth leads to a strong argument that they are becoming over-valued. There are two counterarguments. Firstly that they are vastly under-reporting earnings and could easily ramp them up by cutting down some of their R&D and acquisition cost. Secondly, and more importantly, investors are underestimating the impact of the super-low interest rates on valuations, especially of the big growth companies, notably tech. This is a touch head-scratching and I’m not going to blind you with the science of earnings yields and discounted cash flows, merely to point out that ten years of quantitative easing have made traditional parameters of valuation obsolete and, for now, the market can realistically tolerate higher P/E levels. When interest rates are so low, everything else looks cheap is the answer in its simplest form.
The party will stop when interest rates eventually rise. Valuations will suddenly look far more demanding and multiples will contract. Rates will be rising because economic activity is recovering, and the ‘value’ cyclical and recovery industries such as energy, industrials, miners and banks will have their time in the sun again. Earnings growth will be widespread across the market, not just in limited bastions so there will be no need to ‘pay up’ for this exclusive growth anymore and at this point tech stocks will appear over-priced. This is not likely to happen any time soon; with interest rates anchored near to zero for a few years yet then any big sell-off in tech looks like a buying opportunity rather than an order to man the lifeboats.