A highly technical rally

As the summer draws to a close the S&P500 continues to power to new highs, contrary to expectations earlier in the year when it looked like the corona effect would change the business model, if not forever then for a very long time. The benchmark US index looks set to post its best August performance since 1986. But trends in aggregate indices are not necessarily a good guide to what is happening in corporate America.

The focus of attention of late is the contribution of tech stocks to the surge in US markets. This was brought into sharp focus last week when Apple became the first company ever to post a market cap of USD 2 trillion. The company’s market cap has increased by almost 118% since the March trough, followed not far behind by Amazon whose market cap is up by 104%. At the start of the year, the FAANG sector accounted for 14.1% of the S&P500 market cap; today it stands at 19.8% and since March these five companies have contributed 25% of the increase in the index.

That is a very powerful motive force behind the surge in the aggregate index but the S&P average increase is a much lower, although still-healthy, 65% from the trough. The recovery since March has been described in some quarters as a K-shaped recovery with an increasing divergence between the top performing stocks and the worst performers. It is thus becoming increasingly obvious that this is an unbalanced US rally which is dependent on a small number of stocks. In that sense it is reminiscent of the surge in the late-1990s which proved unsustainable when the tech bubble burst.

One key difference, however, is that the FAANG stocks today have a deliverable product and a proven business model. Investors are not buying companies that offer the promise of a product at some point in the future. Amazon acts as the world’s global market place with a delivery system that can ensure that nearly anything you want can be brought to your door. That said, investors are prepared to pay a very high price to hold the stock of these digital disruptors and price metrics paint a more nuanced picture of the sector. The S&P500 as a whole is trading on a P/E multiple of 27.2x expected 2020 earnings, well above the 21x at the start of the year, but this is distorted upwards by the tech sector. Whilst Google and Facebook are trading at current year multiples of 32x, Apple is at 39x and Amazon and Netflix are running at 71x and 74x respectively (chart). Clearly the surge in FAANG is being driven by a strong earnings performance in recent months, but a lot is priced in for the future and some parts of the tech universe look more expensive than others. I can see why investors are keen to pay a premium for Amazon given the way it is shaping the face of retail, even though it looks very expensive, but Netflix?

From an investor perspective, current trends do not suggest buying an aggregate index tracker since a FAANG index contains all the stocks which are driving the market. Against that, a portfolio diversification argument would caution against putting too many eggs in one basket. Nonetheless it puts the European performance into perspective and perhaps the apparent underperformance of the FTSE100 is a better reflection of average corporate performance than the red hot S&P500.  In that light, it is notable that a recent report from Bank of America pointed out that the market cap of the US tech sector alone stands at $9.1 trillion, which is bigger than the market cap of all Europe ($8.9 trillion).

As one who has watched markets boom and bust a few times over, the surge in tech stocks should remind us of Stein’s Law, articulated by the economist Herbert Stein, that “if something cannot go on forever, it will stop." Or to paraphrase, if a trend can’t continue, it won’t. What this ignores, however, is the timing problem. You bet against a bull market like this at your peril because, as the old adage has it, “the markets can remain irrational longer than you can remain solvent.” With yesterday’s news that the Fed is effectively committing to low interest rates for a very long time to come (I will come back to this another time), debt is simply not going to act as a major constraint on company actions.

At some point, there surely has to be some form of reckoning even if monetary policy is not going to be the catalyst for a market sell-off in the coming years. But what might be the trigger? It is possible that investors will simply rotate out of tech at some point, especially if Covid becomes less of an economic threat (perhaps because a vaccine is developed). This might lead the tech sector to underperform vis-à-vis the “old economy” rather than collapse outright. Geopolitics could play a role if the US-China spat were to heat up. But perhaps the most likely catalyst is that governments start to make good on their promises to introduce a digital tax, particularly in Europe. The US also has a history of breaking up monopolies and history buffs will recall the breakup of Standard Oil which fell foul of anti-trust legislation in the early twentieth century whilst as recently as the 1980s, the Reagan administration took the axe to AT&T.

That certainly will not happen if Donald Trump is re-elected and it is even doubtful that a President Biden would want to go down that path, especially since his running mate Kamala Harris is perceived as very tech friendly. But in this crazy world, we have learned never to say never.