Excerpts Montgomery White Paper on the Tech Bubble and the Overconcentration Risks Prevailing in ETFs
In earlier posts, I did mention about the excessive reliance on FAANG that contributed to the outperformance of the US market indices relative to its international peers and I cautioned that a deflation in FAANG could cause an exit and a deflation of exuberance similar to when our local techs deflated after the Feb correction.
In the wake of the global financial crisis (GFC), index ETFs were meant to offer risk-averse investors a safe and easy way to gain diversification. But nine years into the global market’s bull run, they appear to be pushing US tech stocks into unrealistic valuations in ways that may end badly for many.
In late 2018, we are at a fork in the road where investors may want to reconsider their strategies. The trillions of dollars flowing into ETFs peaked in March and we’re starting to see tech stocks return to earth. The FAANG stocks, which include the likes of Amazon, Facebook and Google, lost a combined US$172.7 billion in value on 10 October alone.
Last year, during our presentations to financial planners and their clients around the country, we began underscoring several important observations.
The first was that the proportion of the market’s high returns that had been delivered by a handful of mega-cap tech stocks was historically unprecedented. The second was that as index exchange traded funds (ETFs) grew they were forced to invest ever greater amounts in these larger companies, irrespective of price or profit outlook. And finally, we noted that the stock turnover of the major US index ETFs was significantly higher than the turnover of even their largest holdings. While this would lead to a combination of high returns, and low volatility on the way up, the reverse would be true when investors began exiting
The tech story so far
The emerging perception of increased regulatory risk for FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks has not only capped prices – it has served as an important reminder that excess profitability cannot be extended indefinitely and will always come up against an opposite force. That may be competition, but it may also be societal rejection, worker protest or regulatory backlash.
Listed among the 10 most valuable companies in the world, Google has a 90 per cent share of all searches. Facebook commands 88 per cent of social media traffic in the US and by some accounts, nearly half of Americans obtain their news from the social network. By 2016, the share of online consumers in the US bypassing search engines for Amazon was 55 per cent, and the biggest Chinese tech companies including Tencent and Alibaba command similar or even larger shares.
As recently as February, the NSYE FANG+ Index (capturing Alibaba, Apple, Amazon, Baidu, Facebook, Google, Netflix,NVIDIA, Tesla and Twitter) were collectively valued at multiples of three times the broader market. The divergence was even greater than during the peak of the tech bubble in 2000. According to Morgan Stanley “the e-commerce bubble has inflated 617 per cent since the financial crisis, making it the third largest bubble of the past 40 years behind only dot.com in 2000 and US housing in 2008.”
While the S&P 500 grew a phenomenal 331 per cent in the nine years since the low of 2009, Amazon was up over 2,100 per cent, Apple over 1,100 per cent, Netflix 5,300 per cent and Google 586 per cent. Adding Facebook, Microsoft and NVIDIA to that list, seven stocks accounted for over 15 per cent of theentire S&P 500 and just shy of 50 per cent of the NASDAQ-100.
As recently as July, Netflix traded at a price-earnings ratio (P/E) of 210 times earnings. Only a few weeks ago Amazon was on a P/E of 156 times. Facebook and Google-parent Alphabet, both of which have been directly linked to privacy concerns, now trade at near 52-week lows.
Much of the commentary during the recent technology boom lauded the superiority of everything from the disruptive asset sharing models of Uber and Airbnb to 3D printing, digital advertising, electric vehicles and the autonomous ‘fourth industrial revolution’. However, the underlying business models of many operators remain unviable without the support of private equity injections at increasing valuations. Where this is the case, investors need to be especially cautious. By way of example, Tesla and Uber continue to be loss-making despite US$50 billion and
US$70 billion valuations, respectively.
Perhaps consequently, a tectonic shift in sentiment towards many tech giants is emerging, spooking investors amid not only a more cautious mood and an extended wait for profits to emerge, but a barrage of negative headlines and the prospect of a political and regulatory backlash.
Tech-laden indices
As recently as a year ago, almost half of the NASDAQ-100 constituents were trading on P/E ratios of more than 200 times earnings. To get to that point, their prices had to rise stratospherically. Further, the S&P 500 Pure Growth Index has a 41 per cent weight to technology and the Russell 1000 Growth Index has a 39 per cent weight. Together they average a 60 per cent active weight to tech names relative to the S&P 500 Index
That is a huge bet and investors are perhaps unaware just how exposed they are to the direction of just a few tech names. Of course, the more concentrated the group of winners became, the more difficult it became for active fund managers to outperform tech-dominated indices. The flows into ETFs understandably accelerated.
Exchange traded index fund operators like Vanguard and State Street weight their products according to market capitalisation, and so index funds become increasingly concentrated and exposed to the largest names, those companies that have already risen dramatically. This time around these names tend to be tech names, and as they outperformed the broader market, more money flowed into them, fuelling even more buying.
But as we have highlighted, investors have consequently placed unrealistic expectations on the potential of many of these companies to change the world, without interruption. They have also underestimated the possibility that stratospheric growth assumptions will be derated amid mismanagement or a backlash from consumers or regulators.
Investors have also forgotten the lessons of history; that amid the hype of emerging new technology – even technology that changes the world – it is often not the investors in the technology that benefit but the consumers of it.
It is my very personal view that the ETF bubble is the transmission mechanism for a technology share bubble. As funds flowed into ETFs at a record-setting pace, ETF operators were forced to buy an ever-narrowing band of winners. As tech shares have rocketed higher, ETF operators have been forced to buy more amid a self reinforcing
circle of enthusiasm that is no different to bond ETF managers buying more debt of the countries accumulating it.
Technology company prospects however cannot be plotted on a smooth 45 degree line heading north east. Yet this is what must be achieved to justify the prices of many tech companies. The allocation to these tech names by ETF operators is not based on any fundamental research. And in many cases, the fundamental research that is being conducted by sell-side analysts on tech names is simply justifying the prices that have been determined by
ETF buying. We have seen this behaviour before. As with the debt market ETFs, there is no price discovery.
The trillions of dollars flowing into ETFs, which peaked at USD$34 billion for the week ending 16 March 2018, distorted all asset prices and those who have invested in US Index ETFs, believing they are diversified, are no more protected than the municipal funds that invested in mortgage-backed CDOs and believed geographic diversification would protect them from default.
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