The big numbers associated with Big Tech are enough to unnerve many investors.
But perhaps the greatest risk to the sector’s out-performance stems not from its scale alone but from the prospect of an economic recovery.
The sector has of course provided a massive boost to those investors brave or clever or even lucky enough to have jumped in this year.
Concerns of a swelling bubble were common over the summer as the world growth-to-value equities ratio, or the ratio of the NASDAQ 100 to the Russel 2000, showed strong similarities to the period preceding the dotcom crash two decades ago.
Household names from the technology sector make up almost a quarter of the value of the entire S&P 500 index about half of the NASDAQ 100. And the big names have done some heavy lifting. Yes, they have pulled back sharply of late with the NASDAQ 100 index shedding all of its August melt-up.
Still, without Big Tech, the S&P 500 would still be down 6% so far this year, not flat.
But should size alone make investors nervous? History suggests not!
According to a research paper from Arizona State University, since 1926 the best-performing 4% of listed companies have driven net gains of the entire US stock market.
Sky-high valuations do make a good deal of sense. These companies’ business models and the gradual digilalisation of our daily lives have contributed to their success. The accumulation of cash on their balance sheets over the years has allowed them to buy back shares – in the second quarter, tech companies accounted for 47% of gross S&P 500 buybacks and their outstanding earnings margins have supported their strong share price growth.
This comes at a time when the divergence between strong and weak balance sheets has never been more critical.
Covid-19 lockdowns across the globe have accelerated structural trends such as working from home and ecommerce.
Ever lower interest rates on top of 16 trillion US-Dollar in negative – yielding sovereign and investment grade debt have made the equity complex a much more attractive asset class while the lower discount rate has pushed valuations higher.
What is more, investors face a lack of choice when looking for pockets of portfolio protection, and 10-year Treasury yields stuck at 0.5 to 0.7% no longer look attractive for this purpose.
This explains how US tech has led the equity market recovery since March 23, a more certainly accelerated by retail flows, momentum playing and Fomo – the fear of missing out.
For as long as markets remain nervous, Big Tech in our opinion is likely to remain in favour. The chance of a disputed or delayed US election outcome continues to favour growth assets and defensive segments of the global equity market.
So what could bring Big Tech back to earth?
Investors in our opinion should watch out for the economic outlook, the vaccine developments against Covid-19 and regulation. Perhaps ironically, the biggest threat may come from a rosier economic picture which in our opinion currently relates to a vaccine breakthrough. In our view, if we get a vaccine that shows signs of being effective, some normalization of global economic growth would probably push market participants to look for the start of a new mini-cycle. This could lead to a rotation and trigger a diversification out of Big Tech towards the most cyclical parts of the equity complex.
In that scenario, we believe the S&P 400 MidCap index, as well as eurozone and emerging market equities, would benefit. Old Tech would also probably outperform New Tech. In addition, enhanced regulatory scrutiny and politicians looking to raise taxes would not help. We do not see these as potential triggers for under performance but they could mar the strong risk-adjusted returns record for these Big Tech companies.
The likelihood of more politicians including tech on their agenda in this election year is also increasing, which could lead to greater antitrust scrutiny.
Meanwhile, major economies through the OECD are working on proposals that could change the international taxation landscape.
In January 2019, 129 countries including the US agreed in principle to a digital tax under the aegis of the OECD / G-20 base erosion and profit shifting (BEPS) initiative. Under this proposal, the digital taxation problem is expected to be addressed by the end of this year.
This all means that, while fears of the Big Tech rally collapsing under its own weight are likely to be misplaced, the sector still has vulnerabilities.
Those investors optimistic on the prospect of a coronavirus vaccine breakthrough might want to look elsewhere.