Technology stocks may have fallen out of favour so far in 2021, but GAM Investments’ Julian Howard argues that the basic fundamentals remain of high quality, which suggests a reassessment is possible.
Comebacks have immense appeal, forming one of a handful of narrative plot types in human storytelling according to Christopher Booker’s The Seven Basic Plots: Why We Tell Stories. 90s hit TV sitcom Friends has just undergone the revival treatment and there are noises that Frasier may go further with a fully-scripted new series. While some of these old shows’ jokes and portrayals are very much of their time, their recent popularity among younger viewers today hints at an enduring appeal. Large-cap technology stocks for their part appeared until recently to be in the sitcom equivalent of the wilderness years, somewhere between their original heyday and the comeback. This year to 31 May, the S&P 500 Index had risen nearly 13% but the Nasdaq Composite of US technology-focused companies was up just 7%, a lag of nearly half the wider market opening up in the space of less than six months, after a stellar 2020 for technology stocks. And yet large-cap tech’s fundamentals remain rock solid. This is significant because in a market environment becoming ever-more prone to fevered speculation, investors may soon yearn for that enduring appeal of consistent profitability. The seeds of a comeback could be in place and market action in June revealed tentative signs of such a recovery in technology stocks.
First, it is worth understanding why large-cap technology stocks fell out of favour in the first place. Since the announcement of the Pfizer vaccine for Covid-19 back in November 2020, investors have anticipated a strong economic recovery from the pandemic and with it, higher interest rates. This has seen a switch to sectors that stand to benefit directly, such as airlines, autos and energy among others. And investors are right about the recovery – for now. A survey of Bloomberg economists revealed that for 2021, GDP growth for the US and UK is predicted to be an impressive 6.6% and 6.7% respectively, with world GDP also predicted to show 6% growth this year. Rising inflation has been part of this story, with May’s US Core Consumer Price Index (CPI) (excluding food and energy) print hitting 3.8%. However, the twist in the tale is that even with growth and inflation now rising, interest rates seem unlikely to follow suit. In late May, respected US Federal Reserve governors Brainard, Bostic and Bullard stated that the current inflation spike would be a transitory function of higher post-lockdown demand hitting lower post-lockdown supply and, by implication, there would be no reason to raise interest rates anytime soon. Furthermore, there are signs that the market is already cooling on the idea of a sustained inflationary era. Analysis of recent changes in US Treasury bond yields reveals significant drops in the inflation expectation element in excess of those of September last year. This may have something to do with the Chinese authorities recently intervening to ban speculation in commodity markets, something so crucial to China’s manufacturing and exporting prowess. Or a key US manufacturing survey recently showing signs of cooling. Both are important because if so-called ‘producer inflation’ eases, it is unlikely to then feed through to sustained consumer inflation over time. And even among buoyant US consumers there could be signs of caution, with US home sales sputtering in June after a strong run. All of this matters, because it is investors’ anticipation of rising rates that has in large part driven the rotation from tech to cyclical stocks. Higher interest rates would reduce the present valuation of consistent revenue-generating assets like large-cap technology, with a much less negative impact on cyclical stocks. However, absent continued strong economic data to support a step-up in interest rates – or indeed the willingness to raise rates regardless – the continued rotation away from large-cap tech appears limited.
Chart 1: Tech tonic – market inflation expectations have actually been falling since mid-May:
Turning to large-cap technology’s intrinsic qualities, the asset class continues to offer defensive features that make it extremely attractive from a portfolio construction perspective. The quasi-monopolies of the largest tech names have created near-unassailable levels of profitability that repeated regulatory intervention has failed to dent over the years. Even this year, as investors focus on economic recovery and express a near-term preference for value and cyclical stocks, large-cap technology earnings have carried on quietly impressing. Taking Microsoft as just one example, latest reported sales growth on the previous year was up 19%, marking the 15th such period of double-digit growth in a row thanks to demand for cloud computing, PCs and its increasingly influential gaming platform. Intuitively, strong fundamentals like this should be prized by investors when equities as a whole are becoming more stretched. Today, the US market is almost ‘priced for perfection’, with the Shiller cyclically-adjusted price-earnings ratio for the S&P 500 Index at over 37x, not far off the near-45x level seen just before the end of the 2000 dot-com bubble. While the historical data points to modest long-term gains still being possible at current valuations, richly-priced markets naturally become more vulnerable to upsets from a variety of quarters in the near term, be they seemingly unrelated volatility in speculative assets like cryptocurrencies or geopolitical risk emanating from China or Russia. Solid fundamentals can take on a valuable defensive significance when volatility and nervousness rise.
Chart 2: Profit of Zoom – analysts anticipating strong earnings growth from technology:
Finally, it is important to separate large-cap tech stocks from the speculative assets alluded to earlier. Few could have missed the huge run-up in cryptocurrencies like Bitcoin, or the ‘story stocks’ such as the Invesco Solar ETF, the Ark Innovation ETF, the AdvisorShares Pure Cannabis ETF or the Defiance NextGen SPAC Derived ETF. All have seen significant price appreciation since the pandemic struck but equally dramatic drawdowns as investor sentiment wavered in recent weeks. From the end of 2019 to mid-April this year, Bitcoin was up nearly 800% in USD terms before then losing around half its value in a matter of weeks when a key sponsor suddenly highlighted environmental concerns stemming from the ‘mining’ of new coins. This extreme volatility is attracting regulatory attention from the US to Hong Kong, with new rules on reporting profits to the tax authorities and the banning of private investor involvement in crypto derivatives being seriously mooted. Perhaps most symptomatic of the speculative fever gripping crypto is the bizarre story of US furniture maker Ethan Allen’s stock price. The firm shares the ticker ‘ETH’ with the ether cryptocurrency and investors have piled into the furniture maker’s stock with an enthusiasm that has transcended its (admittedly good) fundamentals and sent it up over 37% this year. Analysis of social media appears to suggest that many are deliberately investing in the stock purely because its ticker symbol is the same as the cryptocurrency, rather than any assessment of its prospects. In contrast to these ‘story assets’, large-cap technology offers the best of both worlds for investors: innovation and participation in the future but also a critical stabilising ingredient, namely sustainable profitability.
Technology stocks may have fallen out of favour this year but the basic fundamentals remain of high quality, which suggests a reassessment is very possible. With cracks beginning to appear in the current ‘rebound’ narrative, the time for pragmatically and tactically rotating long-term portfolios to cyclical and value stocks may have come to an end as the economic data gradually starts to reflect the new post-pandemic trend growth rate towards the end of this year. We believe this cooling off will likely benefit tech stocks whose long-run profitability outlook remains strong and, when combined with likely continued low discount rates, hints at continued price resilience over sectors that demand improving near-term economic data in order to outperform. Furthermore, at a time of speculative fever that history will probably group with the South Sea Bubble and the Tulip Mania, and where basic revenue generation is being persistently ignored, careful equity investors could well benefit from re-allocating to the intrinsic defensive characteristic that strong profitability infers. On a number of fronts, therefore, large-cap technology deserves a re-appraisal. It would be a comeback that many a 90s TV show would die for.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers.