Commentary on Political Economy

Wednesday, 8 July 2020


Perhaps the most striking feature of the sharemarket’s remarkable rebound from its March lows has been how concentrated the core of that resurgence has been in a handful of stocks.
It is a small number of very large US technology stocks that are at the heart of the market’s seeming indifference to the ravages of the coronavirus through the US and global economies, a phenomenon that is drawing parallels with the dotcom bubble and bust 20 years ago.
Five stocks – Amazon, Apple, Alphabet (Google’s parent), Facebook and Microsoft – now account for about $US6.5 trillion ($9.37 trillion) or more than 25 per cent of the S&P 500’s capitalisation of just over $US25 trillion. Rarely has the market’s dependence been so reliant on the performance of so few.
US equities have enjoyed a FAANG-inspired rally.
US equities have enjoyed a FAANG-inspired rally.Credit:Bloomberg
When the severity of the coronavirus dawned on investors, shares in the big tech companies plunged along with the rest of the market, but not as much. The tech giants fell almost as much as the rest of the market (which includes them) from mid-February to late March – around 30 per cent against the overall market’s 33 per cent fall. Amazon, a perceived beneficiary of the pandemic, was the outlier, falling only about 12.5 per cent.
As the S&P 500 bounced in response to the unprecedented actions of the US Federal Reserve board and the $US2.9 trillion fiscal package approved by the US congress, the tech stocks produced an exaggerated response.
The overall market rebounded 40 per cent to be only 7 per cent below its February highs but the "Big Five" produced gains ranging from more than 50 per cent to more than 60 per cent.
The broader FAANG+ index, which includes Netflix, Alibaba, Nvidia, Baidu, Tesla and Twitter – initially fell 30 per cent before rebounding 66 per cent to be more than 15 per cent higher than its February peak.
To provide some perspective on the market’s valuations of those stocks, the S&P 500’s stocks trade on a price-earnings ratio of 22 and on a multiple of sales to earnings of 2.3. The FAANG+ stocks trade on a PE ratio of 49 and a sales multiple of 6.8.
It’s not dotcom bubble territory, yet. In February 2000, when the Nasdaq market was far more heavily focused on technology stocks than it is today, its stocks were trading on an average PE of more than 100.
Nevertheless, while most of the FAANG+ stocks trade on PE multiples of around 30 times earnings, there are stocks such as Netflix (99 times earnings), Twitter (141 times) and Tesla (8791 times earnings and 9.6 times its sales) that might raise eyebrows. Tesla, while it did make a small first-quarter statutory profit, is still loss-making and still haemorrhaging cash.
Technology companies are benefiting from the lockdowns and the surge in the number of people working from home in response to the pandemic but justifying their valuations requires heroic assumptions about their ability to sustainably grow their cash flows and earnings into the distant future.
Rarely has the market’s dependence been so reliant on the performance of so few.
It might be doable. In 2000, for instance, Amazon had a market capitalisation of about $US76 billion. Today it’s valued at more than $US1.5 trillion. Apple was valued at less than $US5 billion in 2000. Today it's worth $US1.6 trillion. Microsoft had a market cap of about $US500 billion in 2000; today it’s $US1.6 trillion.
Nevertheless, it is also worth considering the lead up to 2000 when professional fund managers were trading anything with a "dotcom" label regardless of the lack of earnings or any discernible pathway to profitability.
Some acknowledged they were playing "pass-the-parcel," or a version of the "Greater Fool Theory," backing themselves to unload the dross before the market inevitably purged itself.
In the search for returns in an environment where only the sharemarket has been offering anything positive, the natural inclination of investors, particularly the retail investors that have played a major role in the market’s comeback since March, is to chase the highest-performing stocks in what becomes a very circular and self-fuelling process.
Elon Musk has admitted Tesla's shares are overvlaued.
Elon Musk has admitted Tesla's shares are overvlaued.Credit:Bloomberg
That’s not to denigrate the FAANG+ stocks or, indeed, some of their smaller fellow travellers. It’s hard to argue that an Amazon, or indeed a Tesla, doesn’t have substance and exciting future prospects but the question of how much value to attribute to their ability to generate the cash flows that validate their future cash flows is a live one in the current environment.
At the start of May even Tesla's chief executive Elon Musk said publicly that Tesla’s shares were over-valued. They were trading around $US700 at the time. They closed at $US1389.86 on Tuesday.
Closer to home Afterpay is raising $800 million at $66 a share. In February its shares hit $39 before plummeting to $8.90 in March and then rebounding to $68 ahead of the capital raising.
This is a loss-making company with a market capitalisation of $18 billion and a price-to-sales ratio of more than 44. The revenue growth is impressive but the valuation is an act of faith reminiscent of the dotcom era when undefined potential – the less defined the better – was more valuable than actual earnings.
The "blue sky" valuations of the technology stocks and the ebullience within the broader sharemarket despite the persistence of the pandemic, which is spreading rapidly again in the US and has regained a strong foothold here, underscore how much of the market’s strength and the valuations of individual companies are reliant on the absence of alternatives rather than fundamentals.
In the long run, it is questionable whether that is sustainable. In the meantime, however, ultra-low returns from the alternatives and markets flooded with central bank liquidity mean that cash has to find a home somewhere and, in recent months, it has flooded into equities and the more speculative end of the market in particular.

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