Over the last 10 years, technology stocks have been the undisputed winner.
Whether it's Apple, Amazon, Microsoft or any of the mega-cap tech names, investors likely have a bad case of buyer's remorse holding just about anything else. For context, the tech-heavy Russell 1000 Growth index outperformed the Russell 1000 Value index by about 7% per year on average over the last 10 years. This is a 2-standard deviation spread, last seen during the late 1990's.
But, while higher this week, Big Tech has shown signs of weakness in recent months. In my opinion, tech's reign of relative dominance has come to an end ... at least for now.
Any good thesis for an underperforming asset always starts with it being overvalued.
It's not that FAANG and other large tech companies aren't great businesses. On the contrary, they are fabulous businesses by most measures. In fact, a number of these stocks remain our largest single stock exposures. They just happen to also be our largest underweights relative to the benchmark.
The problem is that current prices necessitate a level of future growth that will be very difficult to realize. At almost 24% of the S&P 500, the concentration of the largest five stocks is now well known and is a significant contributor to the elevated valuation of the broad market. The S&P 500 is generally inflated from a valuation perspective at 22.5 times earnings over the next 12 months — the 94th percentile of all observations dating back to 1985. Removing just 7 stocks, FAANG plus Microsoft and Tesla, drops the forward P/E to 20x. Historically expensive, but meaningfully less so, especially considering that the earnings of many of the remaining companies have yet to recover.
Despite the unique advantages created by the pandemic, tech's relative advantage from an earnings growth perspective peaked in 2020 as well — failing to exceed the previous high-water mark set in 2010.
Low interest rates have been a key enabler of above-average valuations, but tech is most dependent on rates staying low. Low interest rates increase the value of companies with long-dated future cash flows — many tech companies — via a simple present value calculation. The technology sector is, therefore, most vulnerable to accelerating economic growth and rising interest rates.
Similarly, a recovery in inflation is another risk to tech's dominance. Although unemployment is still elevated and economic slack remains, fiscal stimulus, both past and future, will quickly close the gap at a time when fundamentals are naturally improving amid the vaccine rollout. This should accelerate a recovery in demand, creating upward pressure on prices. Even during the extreme momentum of the technology bubble, the tech sector could not sustain its relative outperformance amid higher rates and inflation.
Finally, the tech sector appears vulnerable from two policy perspectives: tax increases and regulation.
- Taxes: According to data from Empirical Research Partners, just prior to the pandemic the median technology and interactive media firm was paying an effective tax rate of about 13%, more than 5% lower than the median for the rest of the market. Therefore, it is logical to believe that tech's leadership is disproportionately exposed to a shift in corporate tax policy.
- Regulation: As concerns about the power of Big Tech continue to grow, increased regulation is very likely. Although a major shift in the regulatory backdrop for these companies is unlikely in the very near term, an increase in antitrust scrutiny along with momentum building for broader oversight, regulatory risk is certainly increasing.
Taken in combination, the time seems right for tech to relinquish its reign at the top.
Jeffrey D. Mills is the chief investment officer at Bryn Mawr Trust. He has more than 15 years of experience in investment analysis and specializes in providing investment advice to high net-worth individuals as well as institutional clients, including endowments and foundations.