There remains a lurking suspicion among many investors that we are in the midst of a huge bubble in growth stocks generally, and US technology stocks in particular.
The very recent beginnings of a rotation away from conventional growth stocks and towards the conventional definition [low price/earnings (P/E), low price/book value (P/B)] of value have further reinforced these fears.
Is it time to abandon all your tech positions and rush into banks and industrials? This rotation has its echo around the world.
Even in India we have very recently seen domestic cyclicals and banks start outperforming our growth and quality universe.
It is intuitively obvious why investors are worried.
Just six stocks in the US — the so-called FAANGM (Facebook, Amazon, Apple, Netflix, Google, and Microsoft) — have accounted for almost all the outperformance of US equities since 2015.
They have gone up more than four times in that period, while the remaining (the S&P494) is up just 40 per cent.
Their earnings have more than doubled since 2015, while the S&P494 has had almost no earnings growth.
They now account for about 25 per cent of the S&P500, and, in terms of market cap, are equal to the entire emerging markets asset class.
These six stocks are trading at a 100 per cent P/E multiple premium to the rest of the market, a record.
They were trading at parity as recently as 2013.
These numbers, combined with the surge in retail investor participation and margin trading, enabled by zero-commission platforms like Robin Hood, have caused more consternation.
Then we have Tesla, which post the news of its inclusion in the benchmarks, saw in one day a market capitalisation increase that was greater than the entire market capitalisation of Ford Motor!
The euphoria in SaaS (software as a service) companies is something that seems off.
However, the reality is that it is very difficult to time a bubble, and, in fact, even to know if you are in the middle of one.
The Fed, in the US, for example, makes no pretence of its inability to call a bubble.
It may, therefore, be useful to look at some common characteristics of bubbles, and see how they apply to today’s situation.
First of all, valuation on its own cannot be used to call the top of a bubble.
Valuation is a useless timing indicator.
Stocks can always become more expensive, and valuation has to be seen relative to other asset classes.
Today equities may be very expensive on an absolute basis; in fact, they have been so for most of the past decade (using the Shiller cyclically adjusted P/E) but they are cheaper than bonds, and hence the party continues.
Valuations are useful in giving you a sense of prospective returns, but that too for holding horizons of more than five years.
Just as you cannot short a stock purely on valuation grounds, it would be unwise for most institutional investors to exit equities purely based on a valuation model.
Valuation is a necessary and critical but not sufficient condition to make such a tactical asset allocation call.
You would need confirmatory inputs from sentiment indicators, behavioural data, flows, and retail investor activity.
Another point is that all the major asset bubbles in history have inflated during periods of very easy monetary policy.
Rates have been kept super low and liquidity in the system has been ample.
Financial conditions have been stimulative.
Every single one of the great bubbles, dating back to the tulip mania of 1636-37, has started during or just after a period of very easy monetary conditions.
It is easy to see why easy monetary conditions are so important in creating a bubble.
As interest rates decline, most investors take on more risk to boost their expected returns.
As the initial risk taking is shown to be profitable, the temptation is to keep adding more and more beta to your portfolio.
The easy liquidity conditions also encourage and enable leverage.
Thus, many investors ultimately end up multiplying their bets.
As everyone around you is seemingly making money hand over fist, even the conservative investor will get sucked in.
The fact is that bubbles almost never burst while liquidity conditions remain very easy and benign.
They burst only when liquidity tightens and rates go up.
In fact, every major bubble burst only after monetary policy had begun to tighten and all the major bubbles reached their peak within two years of the first rate hike.
Rising rates are toxic for bubbles because they cause a reassessment of risk as alternative asset class returns rise.
As risk is repriced, you typically will get an unwinding of leverage, which inflated the bubble in the first place.
Rising rates also raise the discount rate and scrutiny that investments are subject to. Growth at any cost ceases to be the investment mantra.
The other reason for a bubble bursting could be a sudden increase in the supply of the asset in the bubble.
The tulip mania ended as the high prices incentivised massive planting and once it became clear that all these tulips will be available for sale, prices fell.
Similarly, in the dot com bubble peak of 2000, one of the reasons identified by academics post facto for the bubble popping, beyond rising rates, was a huge slug of stocks, owned by venture capitalists and employees, which came out of the lock-up and was sold in the market.
The final factor quite common to most episodes of a bubble inflating is some form of financial innovation, which either increases the leverage available to purchase the asset in question or expands the pool of investors who can trade in the asset.
Alternatively, the innovation reduces the friction involved in trading in the asset, thus causing trading volumes to spike.
In today’s environment, the advent of zero-commission trading platforms like Robin Hood, which also offer fractional share ownership and enhanced margin limits, would be an example of financial innovation aiding the tech stocks’ rise.
Looking at these various characteristics of past bubbles, it is debatable as to whether today we are in a bubble in technology stocks or not.
Valuation is expensive but not egregious when compared to fixed income.
Some of the sentiment and behavioural indicators are flashing red.
However, what is clear is that there seems to be nothing on the horizon that can puncture any potential bubble, at least going by past history.
Monetary policy is going to remain very easy for the foreseeable future.
There is absolutely no chance of the Fed or any other major central bank hiking rates or cutting back on liquidity anytime soon.
There also seems to be no obvious supply either.
Yes, there is a large pipeline of new issuance in techland as the unicorns are being finally forced to list, but the supply will be staggered over months.
The only issue could be potential legislation to curb share buybacks among technology companies.
This is an unlikely outcome.
There is concern around regulatory risks, but it does not yet seem to pose enough of a threat to derail the business economics of these platforms, or bring more stocks to market.
As discussed, it is not clear as to whether we are in a bubble in technology stocks.
What is clear, however, is that there is no reason why this potential bubble will pop anytime soon.
Unless the investment environment of ultra-low rates and secular stagnation changes, don’t expect any major change in investment leadership.
As to whether the investment environment will change, that is the topic of another essay.