Are we witnessing the bursting of a tech bubble? After eye-watering gains this year, the US technology sector saw declines of around 10% in only four trading days.
The New York Stock Exchange FANG+ Index had been up as much as 85% in 2020 (50% above even its ‘pre-COVID’ peak):
Before recent declines, the extent of gains understandably brought scepticism, and some will feel that this is only the beginning. Market commentary pointed to the rise of non-professional ‘Robinhood’ investors (named after a popular investing platform) or the role of heavy buying by Softbank in Japan as indications that the moves were far more about return chasing than reality.
However, there are strong counterarguments to this bearishness. The outperformance of the US market and its technology sector is neither new, nor completely divorced from the realities of a world in lockdown. And we should be very wary of the temptation to think that the market, or even certain sections of it, is ‘stupid.’
As behavioural investors, looking at price and valuation are central to trying to identify opportunities, but so is understanding what is driving these moves. By understanding what is going on in fundamentals we can begin to make an assessment of just how ‘irrational’ market behaviour truly is.
Unpicking the outperformance of US-technology
The long term: ‘US-ness’ and profits delivery
The outperformance of the US stock market relative to the rest of the world, and of technology stocks within that, has been a headache for active managers for a number of years now.
The US is a large part of global passive indexes, and technology is a large part of the US. When the largest part of your universe is outperforming everything else by such a large degree, the task of profiting by ‘doing something different’ is challenging.
This US outperformance has been driven by superior profits delivery for over a decade:
Since the financial crisis you can see the strong relative performance of the US against the rest of the world as Europe was hit by the Eurozone crisis from 2011, and emerging markets struggled in the face of commodity price declines from 2014 to 2016, and in the recent ‘trade war’ phase.
Here’s how the US technology sector has looked over that period:
So while it may be irritating for ‘value investors’ and those faced with the task of outperforming passive indices, it cannot be said that the longer term dominance of the US and technology are entirely divorced from reality.
This is as true so far this year as it is over the long term. We have heard much of how technology firms’ revenues have been more resilient and, in some notable cases enhanced, during the lockdown period:
As I noted a couple of weeks ago, the wide divergence in returns between different sectors so far this year is relatively unusual, but not unjustified.
The short-term: Convenient narratives and loose anchors?
Nothing in the above precludes US technology from being a bubble. When euphoria takes hold in markets it is usually because something has happened in the real world which is then extrapolated, only then does ‘price become the story’ and investors begin to chase returns.
There have been signs of this type of behavioural influence. Most compellingly, the last month or so has seen significant price outperformance of US technology even though relative earnings outperformance has not been in evidence for several months, and has even modestly reversed recently:
Also telling are signs that, in the absence of the earnings story, investors have seemed to look to other rationales to justify a preference for these stocks.
One of the most common of these is that because technology companies often represent ‘long duration’ assets (their return profile is more about profits in the future than dividends today), they have gone up because rates are falling and stimulus increasing.
This argument has some validity, but as behavioural investors it is important to examine cases where the prevailing narrative changes and appears to reveal inconsistencies. Why is this suddenly an issue now? Why is this ‘duration factor’ be important for technology, but not other ‘growth’ areas of the market? Why would that explain a 10% gain in the Nasdaq in August, even as long-dated Treasury yields rose?
The reality would seem to be that low rates may be necessary, but not sufficient to justify the extreme re-rating we have seen in areas of the technology market in the last three months. A recent piece from AQR examined the empirical relationship between duration and factor performance and found it wanting, highlighting the importance of other variables. What is more interesting however, is that investors would begin to make this argument now.
It is also notable that much commentary has greeted the recent ‘correction’ as something that was needed, and ultimately a good thing for the technology sector. These types of argument are always odd, but it might be telling us something. It seems unlikely that commentary would greet another 10% decline in European banking stocks as a positive development for investors.
In both the ‘duration’ and ‘necessary correction arguments, we can see a desire to ‘want to believe’ which itself can be suggest of behavioural influences at work.
Very recent gains in technology have shown signs of behavioural influences at work, but we should be wary of confusing this very short term behaviour with broader trends.
Though we have seen strong gains and a significant re-rating, a large part of that does seem to reflect the fundamental backdrop. Moreover, if we look at the balance of commentary today it is still relatively easy to find example of sceptics: many still compare the current situation to the tech bubble of the late 1990s despite very different conditions with regards to underlying profitability and prevailing interest rates. Such voices are very hard to find in the midst of a genuine bubble.
It would seem then that much of the price behaviour that can be characterised as ‘bubble-like’ has only taken place in the last couple of months, and has already unwound pretty significantly. As we have mentioned in the past, high levels of volatility can be expected in assets that are harder to value and this is certainly the case in significant chunks of the technology universe, and particularly so today. Taking on such volatility can be a fruitful source of return but we need to ensure we examine our own beliefs: it is just as possible to have a bias to calling bubbles as it is to get caught up in the bubbles themselves.