“Say two thousand, zero, zero, party over, oops, out of time.”
With apologies to the late performer Prince, after a few weeks of market fluctuations kicked off by the technology sector, is anyone else getting flashbacks to the beginning of this century?
Valuations on companies in the technology sector, in particular stalwarts like Netflix or Amazon that sport price to earning ratios, or P/Es, of 100+, have appeared elevated to many observers for several quarters. Those valuations implied that the tech giants would be growing quickly for decades, but the reality is that investor greed likely drove the valuations as much as any expected growth by the individual companies.
In 1999, tech stocks traded up to dizzying levels during the internet bubble. It seemed as though any company with “dot com” in their name that sought funding had investors clamoring to get in on the action, even if they had never turned a profit. The allure of easy gains available during that bull market blinded investors to the risk of their decisions. And the consequences were sizable, given that according to Bloomberg, between 2000 and 2002, the tech-heavy NASDAQ index dropped about 80 percent and it didn’t get back to its March 2000 high until 2015. While it was thought investors learned their lesson when the bubble burst, it appears the lessons have faded and risk aversion is absent in more than a few investors’ minds.
The rise of tech stocks wasn’t the only thing going on in 1999, U.S. stocks outperformed their international counterparts and we also saw growth stocks outperform value stocks. It was an unusual time, as the data suggests that during 10-year rolling periods since 1927, value stocks outperformed growth stocks 84 percent of the time. As you can see in the chart below, which shows the Russell 1000 Growth Index in blue and Russell 1000 Value Index in orange, that trend was reversed in the run up to the dot.com boom. On the far right side of the graph, you can see a similar gap between growth and value has emerged over the last few years.
Source: Bloomberg. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Unmanaged index.
Now, investors aren’t just throwing money at anything connected to tech like we saw in 1999, but the situation is similar enough to warrant examination, especially amidst the recent drops we’ve experienced in stocks like Amazon, Netflix and Apple.
The reality is the tech stock darlings’ rise has been driven by a variety of factors this time, one of which is the move towards investing in passive index strategies. This shift has meant that the biggest companies get the biggest proportion of additional dollars from investors buying into those strategies. Thus, today’s market is not identical to the late 1990s’, as most investors are not intentionally seeking out tech companies.
To be clear, the current condition isn’t simply about passive funds, but their rise is also leading to a gradual reduction of active managers which may be a contributing factor too. Historically, price discriminate buyers and short sellers helped balance the market. In some cases, these types of investors have also been the key mechanism to correcting anomalies, as witnessed in a few marijuana stocks recently last year. If people think a company is over-valued they may bet against it, but short-sellers have been swimming against strong currents recently as index funds holding so many dollars of Amazon, etc., purchase more shares with each contribution.
Now, today’s risks aren’t related to the individual companies at the top of the indexes, like Amazon or Apple, going bankrupt because they are businesses with limited or no debt and their products and services that are widely used. Instead, the risk is related to their momentum which is based on the overall positive sentiment of the market. We’re starting to see the effect of that momentum losing steam already, as almost every world market has corrected, with the exception of U.S. large cap stocks which are teetering on the edge of a technical correction, i.e. 10 percent off peak levels.
What we’re seeing right now may be a brief hiatus or a return to normal for tech stocks on a long-term march higher. Ideally, this will be a period that teaches some overzealous investors a lesson before it’s too late. With a nine percent drop in the Nasdaq Composite Index through Oct. 30,the market is telling us is that there’s a mismatch between the growth expectations for these companies and what’s realistic in an environment where interest rates are now above three percent. That’s not to say we should all start to panic, but it is a good reminder not to let greed override the more logical parts of our brains when it comes to investing.
For quite some time now, strategic investors have looked out of touch. If you look at hedge funds, supposedly the smartest guys and gals in the room, they have mostly gotten crushed by this tech momentum that has helped lead the rally for the first nine months of the year and a good portion of the last five years. According to Bloomberg, the diversified global investor, who holds international and emerging market stocks with their attractive fundamentals, has been trailing the S&P 500 Index most of this year as well. At the same time, if you owned value stocks, which as I mentioned earlier, for the past 90-plus years outperformed growth stocks 84 percent of the time on a 10-year rolling basis, you’ve been hard pressed to keep pace too.
The only time we witnessed a similar phenomenon occur was—you guessed it—during the dot com boom of the late 1990s. What we’re seeing now is that smart investors appears to be getting it right again, and perhaps preventing our current tech bubble from overinflating to the point of dramatically bursting and saving us all a little, or a lot, of pain in the long run.
If things are back on a more predictable track, expensive tech stocks that didn’t do as well as value stocks or international stocks the past few weeks could be in for a bumpy ride. This is what we need to happen if we hope to avoid repeating our early 2000’s history.