Tech Sector: Bubble or Not?

Author: David R. Kotok, Post Date: November 20, 2017
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Seventeen and a half years ago, on April 1, 2000, we published a piece entitled “Will the NASDAQ sell-off become a crash?” We have now retrieved that piece from our archives and posted it on our website. Here is the link to the original piece: http://www.cumber.com/pdf/nasdaqpe04012000.pdf.

In preparing that piece in 1999–2000, we evaluated the stock market at the time and made a theoretical calculation in which we merged two companies, Cisco and Microsoft. We assumed that their reported earnings were accurate. We found that the two companies together had reported earnings of $10 billion, and their merged theoretical market valuation amounted to $1 trillion. Our conclusion at the time was fairly straightforward: There was nothing wrong with either company. Both Cisco and Microsoft were fine, large, developing, worldwide leaders in the Technology sector. The stock price, however, was wrong. At 100 times earnings, the price of the theoretically merged company’s shares was not justified by any valuation technique. The combined GDP of all countries in the world was estimated at $30 trillion at that time.

We concluded in our piece that the NASDAQ at 5000 was setting up for a crash. The fourth page of that 18-year-old piece measures the value of Cisco against a list of companies (that list included Apple). Take a look at that list, and you will see that Apple had a market cap of about $23 billion and Cisco had a market cap of over $500 billion.

Eighteen years ago we forecast that the NASDAQ 5000 would lose over two-thirds of its value before the crash and the sell-off ran their full course. Never did we think that the result would be a loss of 80% of its value from peak to trough.

Today, we hear a constant litany about technology stocks, and we are questioned about the current time as a replay of the bubble that occurred almost two decades ago. Acronyms like FANG and FAANMG and others are used to aggregate the large-cap tech stocks like Facebook, Amazon, Alphabet (Google), Apple, and others. The collective weight of the Tech sector today is about 25% of the total stock market weight of US stocks. And the value of the entire US stock market in relation to the US GDP is now at the highest level ever, with the sole exception being the tech stock bubble period of 1999–2000. By the way, the 25% weight threshold has marked the top or close to the top of every sector’s peak, not just Technology’s.

We can also note that the market cap of Apple is approaching $1 trillion. And we see Apple now with a forecasted earnings rate that will be four times the earnings noted in the study done nearly two decades ago. If Apple can meet the expectations about its new products and services and worldwide growth, one can argue that it will go higher in stock price and that the earnings and revenues will continue to grow. The same can be said for others in the Tech sector.

So is the current Technology sector a bubble?

Yes, it is if the earnings don’t grow or start to decline. No, it isn’t if the growth rate continues. Which will it be? Determining an answer to that question requires assumptions and estimates, which are the bread and butter of security analysis.

Our conclusion is that the pricing of stocks in the Technology sector currently reflects market prices of assumed good outcomes. The positive outlook for these companies is mostly priced in. In order for them to continue their stellar stock performance, they need to continue to produce the earnings growth that has powered them to the present level.

This set of circumstances is different from the tech stock bubble of 1999–2000. Then you had companies that had no profits and sported market caps in the billions. Instead of price/earnings ratios, we had price/fantasy ratios. Note that in my study written 18 years ago I ignored the companies that were not earning money and eliminated them. That is why the study focused on Cisco and Microsoft at the time it was written. They were real companies with real earnings. The same is true for the present mix of FAANMG.

In our managed portfolios we had carried an overweight position in the Tech sector with pleasant results. We have ratcheted that back.

Will the stock market give us a correction and an entry? Maybe. Will we be reallocating to other sectors? Maybe. Are we abandoning the Tech sector, or just rebalancing the weight to reduce the risk of heavy concentration? Yes, it’s the latter.

Of course, any of this may change at any time.

David R. Kotok 
Chairman and Chief Investment Officer
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