Are You Expecting Another "Tech Wreck" Like 20 Years Ago?
Michael Salerno
No, we doubt the equity market’s heightened tech concentration will trigger an imminent correction. Rather, tech stocks’ outsized weighting reflects their superior growth and free cash flow this cycle. Amid a lackluster macroeconomic backdrop, historically low discount rates have boosted the appeal of the most profitable and liquid segment of the global equity universe, namely mega-cap US technology.
On the face of it, concerns about an increasingly top-heavy and tech-driven equity market are logical. The five largest US stocks by market cap —Microsoft, Apple, Alphabet (Google), Amazon, and Facebook —now make up slightly more than 18% of the S&P 500 Index, exceeding their dot-com bubble counterparts’ combined weighting at the March 2000 peak. Also, while two of the dot-com top five were old economy stalwarts, General Electric and ExxonMobil, all five of the current leadership are tech-driven disruptors, regardless of their official sector classifications.* Furthermore, on a combined basis, the overall information technology sector plus the so-called FANGs (Facebook, Amazon, Netflix, and Google) now account for a full third of the S&P 500’s total market cap.
With increased size has come greater contribution to the market’s overall returns, particularly when the largest stocks outperform to the extent they have over the past three months. Yet, the market’s recent performance has not been nearly as concentrated as it was during the last months of the dot-com bubble. Though recent measures of overall market breadth have been narrower than average and investor positioning and sentiment are somewhat elevated, none are currently ringing alarm bells.
Compared to consensus expectations for the largest five stocks at the height of the dot-com bubble, sell-side analysts have penciled in similarly robust fundamentals for the current top five through 2021: double-digit sales and earnings growth and profit margins nearly twice that of the overall market. Yet, current valuations —though by no means cheap —are far less stretched. In aggregate, today’s leadership recently traded at 30 times consensus forward 12-month earnings versus 47 times for the dot-com darlings at the March 2000 peak. Perhaps most importantly, over the past three years the current group in aggregate has reinvested nearly half of operating cash flow into growth capex and research & development, potentially laying the groundwork for sustaining their competitive advantages going forward. And despite healthy reinvestment, Apple and Microsoft have returned prodigious amounts of cash to their shareholders via dividends and share buybacks, generating total shareholder yields in the mid-single digits.
Granted, today’s tech behemoths are not altogether immune from risks; however, the challenges they face are more longer term and idiosyncratic in nature (and tend to hinge on government action). For example, policymakers in both the United States and Europe have begun scrutinizing the competitive and data privacy practices of Alphabet, Amazon, and Facebook in particular. Governments are also mooting digital transactions taxes and online sales taxes, which could take some wind out of the tech giants’ future sales and profits. Separately, Apple’s supply chain and revenues are both exposed to China and therefore could be negatively impacted by any renewed trade hostilities between the US and Chinese governments.
One shared near-term technical risk to monitor is this group’s popularity among hedge funds. Crowded positioning and overlapping business models could lead hedge fund investors to exit these stocks en masse if one of the firms encounters a fundamental setback, particularly given elevated expectations. Relatedly, with tech stocks carrying rather full valuations, if global growth accelerates and/or if interest rates back up, then the overall market’s performance leadership could rotate sharply from mega-cap tech to more cyclically geared sectors and lower-priced value stocks. Longer term, a common strategic concern involves the tech leadership’s stranglehold on the market for cloud computing services and their reliance on fast-growing —but still unprofitable, in some cases —private equity–backed businesses for a lion’s share of the demand.
While the US tech giants have come to dominate the global equity market via valuation expansion, their meteoric rise has also been due to very strong fundamentals. Though not without risks, they have been a source of growth and stability in an uncertain, “lower for longer” environment. Cyclically speaking, they could certainly begin to lag more economically sensitive segments of the market if activity picks up in any sustained way. However, we don’t believe the stock market’s increasingly concentrated exposure to a handful of mega-cap technology names is itself a warning sign that a major sell-off is looming.