Are We in Another Tech Bubble?

Are we in a tech bubble? It’s hard to ignore that question when the tech-heavy NASDAQ Composite is up 33% through November 9, besting the runner-up S&P 500 Index by over 20%.

Tech companies are the perceived winners in a post-Covid world, resulting in soaring stock prices with no end in sight. It begs the question, are we seeing a repeat of twenty years ago, and if so, could it bring the markets down?

The World Wide Web

Let’s begin with a quick historical overview. Dot-com mania started around the mid-1990s and reached a peak in early 2000. As more people gained access to the Web, all eyes started focusing on Internet stocks. Stocks began to skyrocket and valuations hit extreme levels. Anything less than a 20% return was a mark of defeat.

The NASDAQ rose exponentially, from around 1,000 in 1995 to over 5,000 by early 2000. Investing in anything else seemed foolish.

Unfortunately, we all know what happened next. The bubble burst, fortunes were lost and most of these companies disappeared. On March 10, 2000, the Nasdaq Composite Index hit an intraday high of 5,132. By October 10, 2002, it dropped over 78% to 1,108 – wiping out all five years of gains. It took nearly 15 years to regain that previous high.

The shadow of the 2000 dot-com bubble still looms large, especially given what we’re seeing today. But before we can draw parallels between then and now, it’s important to review all the facts.

Sector Separation

If we examine the best and worst-performing sectors of the S&P 500 (technology and energy, respectively), they are at the widest point since 2000.

While this doesn’t necessarily imply a bubble, it does suggest there are risks. Throughout history, no one sector has outperformed forever. Also, while technology has done well, energy has been hit exceptionally hard, contributing to the widespread. The market tends to get over-enthusiastic about good performers and unfairly punish those out-of-favor.

Increased concentration in the largest companies

The S&P 500 index, led by the tech sector, has surged to new highs. But this masks a big dispersion between the largest holdings and the rest of the index. Much of the run-up is concentrated in the five largest names by market capitalization (Apple, Microsoft, Amazon, Facebook and Alphabet).

According to JP Morgan, the index was up 1.2% year-to-date through November 2, 2020. The five largest names returned 38%, but the remaining 495 were down by nearly 5%.

The weighting of the largest S&P 500 stocks is also at record levels, surpassing those seen during the tech bubble. Information tech is also at its highest weighting since 2000. However, it’s interesting to note this sector has a much higher contribution to earnings (green line, right-hand chart) than in 2000 when prices depended on earnings that may not be realized for years if the business model even worked.

Many tech firms are experiencing the tailwind from the pandemic. Unlike two decades ago, their growth has been reinforced by clear improvements in their fundamentals. There is still a lot of risks out there, but it appears less extreme now than before.

Stretched Valuations

As illustrated by the line chart below, the S&P 500 Index is at the most expensive level since the tech bubble. However, there is a big difference between the valuations of the largest stocks compared to the rest of the index.

If you exclude the top five stocks, valuations are only modestly higher than the 20-year average.

Source: JP Morgan Weekly Market Recap, November 2, 2020

Top names also rotate over time, and being big and profitable doesn’t guarantee future success. It was only a decade ago that Exxon Mobil was the largest company in the S&P 500.

Rotation of big names also doesn’t equate to a market crash, as witnessed by the performance of the stock market the last decade.

What does it all mean?

For weeks, investors have raised concerns that high tech-stock valuations could trigger another downturn, similar to 2000.

What appears different now is that tech outperformance is being driven by the largest, most profitable companies in history. Many companies then did not have sustainable business models and ultimately succumbed. But while it’s unlikely today’s top names will go under, they could certainly underperform for a long time if earnings cannot support their lofty expectations. At some point valuations will matter.

Fundamentals also matter. Unprofitable companies besides these top names, that lack sustainable cash flows, are just as vulnerable now as they were then. This is one of the reasons BDF tilts toward profitable companies, which are proven to outperform over time.

Whether or not we are in a tech bubble is debatable, but most would agree on the risks. Will investors burn themselves again because they refuse to take a lesson from history? Hopefully not.