Last August, I wrote a blog post arguing that largest technology and internet companies -- Amazon, Apple, Facebook, Google, Microsoft -- would never grow into their collective market capitalization. That post wasn't a market call; I didn't predict imminent doom. Today I think the risks of owning these and other large tech companies are much greater, and I'm willing to stick my neck out and advocate selling/shorting their stocks.
I've split this post into four sections:
1. Some comments on valuation
2. Why the internet giants' actions since January 6th will hurt them
3. Tech leaders are showing signs of technical weakness
4. The Fed can't prevent the stock market from selling off
Comments on valuation
In last August's post, I mentioned that the all five of the United States' largest companies by market cap were tech/internet businesses and that historically, "being one of the top companies by market cap has been a contrary indicator, both for the company itself and for the industry to which it belongs."
Today, technology is even more dominant. Electric-vehicle manufacturer Tesla has become the fifth-largest company by market cap, relegating Facebook to #6.
I can't find any previous instances of one sector monopolizing the market's highest echelon. In 1980, at the peak of an oil bubble, three of the six largest US stocks were oil companies: Exxon (#3 in overall market cap), Amoco (#5), and Mobil (#6). In early 2000, when the dotcom bubble crested, the tech companies with the highest market caps were Microsoft (#1), Cisco (#3), and Intel (#6).
Additionally, the five biggest tech stocks account for 21.7% of the Standard & Poors 500's aggregate market cap. (The six biggest are 23.4%) The last time five stocks accounted for such a large share of the index was the 1970s. And back then the S&P's top echelon was more diversified. In 1970, for instance, the index's six largest constituents all belonged to different industries. So technology's dominance, with tech/internet companies holding all of the S&P's top slots and those slots being such a large share of the index, is unprecedented.
The high market caps reflect high expectations. Of these six companies, Facebook is the only one that trades below 30x earnings.
In some cases, the expectations will obviously never be fulfilled. Apple, the largest company by market cap, earned $66.3 billion of operating income in its fiscal year ending September 2020. In its 2015 fiscal year, it earned $71.2bn. Profits have stagnated even though the price of Apple's top-of-the-line smartphone has increased over time, in contrast to the electronics industry's typical deflation. Apple has maintained its profits only by shrinking its products' consumer surplus.
The company's average operating income over the past six years is $65.6bn. At the current corporate tax rate (21%), that's $51.8bn after tax, or $3.08 per share at today's share count. So at $127 per share, Apple trades at 41x this average earnings figure.
In the original article, I argued that the markets for cloud computing and online advertising would ultimately be smaller and less profitable than most investors assume. Nonetheless, their historical growth has been impressive. Apple hasn't grown in years.
Tesla, the fifth-largest company, has an even crazier valuation. The stock trades at $826 and analysts expect it to earn $2.34 this year, for a price/earnings ratio of 350. Much of those expected earnings derive from selling regulatory credits to competitors rather than building cars. Previously, Tesla was chronically unprofitable.
Excessive market caps and excessive valuations aren't limited to these six mega-cap stocks. There's a long tail of large- and mid-cap tech stocks that are equally pricy. The S&P 500 has an aggregate market cap of $31.7 trillion. The NASDAQ 100, which comprises the hundred largest stocks on the NASDAQ exchange and is predominantly a tech/internet index, has an aggregate market cap of $18.1tn. So the NASDAQ 100 is worth 57% of the S&P 500. The figures aren't strictly comparable, because a few of the NASDAQ 100's constituents aren't S&P constituents, but nonetheless tech/internet stocks have overwhelmed the American stock market.
Political and reputational challenges
After the riot that took place in Washington D.C. on January 6th, Facebook and Twitter banned Donald Trump from their platforms. Other tech companies like Shopify and Snap soon joined in blacklisting Trump. A Twitter clone named Parler then became popular among right-wingers, who briefly made it one of the most downloaded smartphone apps for both Apple and Android phones, before Apple and Google (Android's owner) banned it from their app stores. Amazon then banned Parler from Amazon Web Services, which Parler had used as its sole web host, knocking it offline. As of today, it remains offline.
This series of events creates several problems for the companies involved:
• Many right-wingers now feel alienated from social media platforms. Some will leave these platforms, which they think are discriminating against them with one-sided censorship. I don't know how widespread this will be, but with investors perceiving the social media companies as secular growers, even moderate defections could hurt the companies' valuations.
• After what Amazon did to Parler, many other companies will reconsider putting themselves at the mercy of a cloud host. As above, I don't know how widespread this will be, but with investors valuing cloud hosts as secular growers, even moderate defections could hurt the stocks.
• Many foreign leaders have publicly criticized Trump's social media bans, including Angela Merkel. Mexico's president, Andres Manuel Lopez Obrador, has "vowed... to lead an international effort to combat what he considers censorship by social media companies."
Despite complaints of censorship from AMLO and other leaders, I think their true concern is slightly different: they see the social media platforms' actions as threatening their sovereignty. These political leaders want the unfettered ability to communicate with their citizens, and they want their governments to have the ultimate power to regulate their citizens' speech, both of which are incompatible with foreign social media companies banning politicians arbitrarily.
As countries respond to the tech giants' perceived infringement of their sovereignty, we can look forward to many jurisdictions hitting Facebook and its ilk with lawsuits, fines, and punitive new regulations.
Signs of technical weakness
Technical analysis suggests that the tech/internet bull market is losing momentum.
From the stock market's panic low last March through August, large tech stocks led the market higher. The NASDAQ 100 outperformed ever other major index during this period. Then on September 2nd, the NASDAQ 100 hit an all-time high before quickly selling off 14%. It subsequently rebounded, but from Sept. 2 through last Friday, the NASDAQ 100 has trailed every other major index, and its most prominent constituents have performed even worse.
The FANGMAN stocks -- Facebook, Amazon, Netflix, Google, Microsoft, Apple, and Nvidia -- have all underperformed the NASDAQ 100 since Sept. 2. Other leading tech stocks have been similarly weak. Adobe and Salesforce have also underperformed significantly since September. Advanced Micro Devices, Shopify, Spotify, and Square initially did will after the September selloff but have noticeably underperformed the NASDAQ 100 over the past 4-5 weeks. Paypal outperformed the index after September but has decelerated more recently.
By contrast, Tesla is up 85% since Sept. 2. Arguably, Tesla alone is keeping the NASDAQ 100 going.
There are two intuitive explanations for tech's weak performance. One is that the large tech/internet companies benefitted from the covid lockdowns and now, with mass vaccinations in progress, traders are selling these covid beneficiaries and replacing them with "re-opening plays." Another is that a Democratic regime offers the prospect of more government spending, which should push interest rates and inflation higher. Since tech stocks trade at high P/E ratios, they have high duration, and this makes them sensitive to rising rates.
I don't think these are the real reasons why tech stocks have lagged. They started underperforming in September, more than two months before the election and the announcement of the first successful vaccine, and their underperformance was actually slightly greater before early November than since then. And the tech giants differ in how much lockdowns helped them and reopening might hurt them, yet they have nearly all underperformed.
I want to offer an alternative explanation: rather than sector rotation into re-opening plays, the tech giants' weakness is a result of rotation into even more speculative tech plays.
As many commentators and news articles have discussed, retail investors have been the most enthusiastic participants in the market's ongoing rally, and retail inflows have been the fuel propelling the market higher. In June, Robinhood, an upstart broker popular with younger traders, handled more trades than any of the established retail brokers, which themselves were experiencing a surge of new account openings and trades. This trading frenzy isn't limited to the U.S.: retail investors in countries like Russia and Kazakhstan have piled into American tech stocks.
As measured by trading volumes, and more anecdotally by comments on message boards, retail traders are increasingly shifting their attention away from established tech companies and toward securities that offer the potential for exceptionally rapid price gains. Among them: Tesla and various "me-too" electric-vehicle and autonomous-vehicle startups that are piggybackng on Tesla's popularity, chronically unprofitable fuel-cell manufacturers, biotechnology startups, special-purpose acquisition companies (SPACs), penny stocks, call options, and bitcoin. In other words, retail traders are migrating from securities that are speculative because they trade at high valuations to securities that are intrinsically speculative.
This dynamic has the potential to destabilize the market for several reasons:
• Most of the tech giants rose 70%, 100%, or more in less than six months after the stock market bottomed. If this experience has trained retail traders to expect 100% returns every six months and to consider the prospect of "dead money" intolerable, then we have no idea how they would react to a major selloff that is outside of their experience and that challenges their expectations. Just as they've responded to a rising market by buying consistently and aggressively, they might respond to a falling market by selling aggressively.
In my experience reading message boards, many retail traders realize that the stock market is a bubble and are participating cynically. They assume that they will be able to get out in time by selling to a greater fool. If they get caught in a selloff and belatedly realize that they are the greater fool, look out below.
• As the rally lengthens, more retail traders are participating by buying call options and in some cases selling put options. One brokerage executive observes retail "traders buying short-term out-of-the-money calls -- all-or-nothing bets that a stock will rise in a short period -- a trend that he hasn't seen previously." This preference for short-term options can amplify market moves in both directions. If a trader doubles his money on a monthly call option, he can use the proceeds to buy more monthly calls. So long as the market rises, he can steadily increase his bullish wager. But if market sells off sharply and doesn't immediately rebound, it could destroy his account and remove a source of demand from the market.
• Underwriters have responded to the enthusiasm for speculative securities by flooding the market with them. In 2020, 248 SPACs came public, raising $83bn. In 2021 to date, 53 SPACs have come public, raising $14.7bn. By contrast, all the SPACs that came public in 2019 collectively raised $13.6bn. Likewise, hot tech startups like Airbnb, Doordash, and Snowflake have raised billions through initial public offerings in recent months. Supply threatens to overwhelm demand, and the supply/demand imbalance will worsen when the recent SPACs and IPOs hit their respective 180-day marks and their lockups expire.
Although the tech mega-caps are no longer retail traders' preferred speculative vehicles, retail still collectively owns an enormous amount of their stock. I would expect a selloff in SPACs, recent IPOs, low-priced stocks, and the like to spill over to the tech leaders.
Apart from these specific risks to the market's stability, technical analysis suggests a more general reason to be cautious. Many technical analysts stress the importance of breadth to market health: the more stocks participate in a rally, the longer it's likely to last.
Today breadth is strong, as measured by up versus down volume and the number of stocks making new 52-week highs, but that strength is deceptive. A share of Amazon costs $3104. A share of Google costs $1727. A share of Facebook costs $251. SPACs are typically issued at $10 per share, and some of the stocks that have become retail favorites trade at even lower prices. Up/down volume on the NASDAQ is meaningless when the down volume is in Facebook and the up volume is in companies like Jaguar Health (last trade: $3.30, up from $.25 two months ago, with hundreds of millions of shares trading on some days).
Likewise, the proliferation of SPACs has reduced the value of new highs as a measure of market health. Many SPACs have multiple outstanding securities, which inflates the new-high numbers. For instance, INSU Acquisition Corp. II, INSU Acquisition Corp. II class A, and INSU Acquisition Corp. II warrants each hit a new 52-week high last Friday.
The New York Stock Exchange, which has fewer speculative securities than the NASDAQ, has weaker breadth.
If one measures breadth not by share volume but by the aggregate market cap of securities that are rising versus the aggregate market cap of securities that are falling, then the tech sector is deteriorating. Speculative enthusiasm is increasingly limited to market sectors that, while they have a large number of discrete securities outstanding, are a relatively small part of the overall market.
The Fed won't save speculators
At the depths of the covid selloff last March, the Federal Reserve took significant actions to support financial markets. Many traders have interpreted this as encouragement to speculate because "money printer go brrr" and "the Fed has our backs." I'm not sure that it does. While the Fed undoubtedly cares about asset prices, I don't think it could or would necessarily intervene to stop the stock market from falling:
• The Fed's actions last March occurred during an unprecedented economic decline, which gave it a rationale for taking unprecedented actions. A future Fed intervention would occur as the economy is recovering from covid lockdowns.
• The Fed's actions, despite their radical nature, were aimed at stabilizing the bond market rather than the stock market. The Fed buying stocks would be controversial, and I would expect it to face political opposition.
• The largest tech companies generally have little debt, and some have significant net cash. Their stocks could fall significantly without spill-over to the bond market, meaning the Fed would have less justification to intervene to stop a tech-centric selloff.
• Valuations are higher and speculation is more extreme today than during last March, or even at the market's pre-covid peak last February.
• If a selloff develops enough momentum, it can take on a life of its own, with traders selling to meet margin calls, to get ahead of expected further declines, or out of blind fear rather than as a reaction to changing fundamentals. Fed intervention wouldn't necessarily stop this kind of out-of-control selloff right away.
• As mentioned previously, I think options trading has the potential to amplify market selloffs. So even if the Fed wanted to prop up the stock market during a selloff, it might be sudden and sharp enough that the Fed couldn't react immediately.