Top Market Takeaways: 3 need-to-knows on tech

The tech sector is partying like it’s 1999. How long can it last?


Market Update

A cruel summer for the bears

The first week of August has not disappointed investors. The S&P 500 is trading roughly 1% from all-time highs. The sectors that aren’t in the green this week (utilities and real estate) are traditionally viewed as “safe havens.” A mix of secular growers (tech +4.6% & communication services +3.0%) and cyclical stalwarts (energy +3.1% & industrials +3.0%) led the way.

The NASDAQ 100 made its fourth all-time high in a row on Thursday (its 17th since Memorial Day). U.S. high yield bond spreads (lower spreads mean lower perceived risk of default) plummeted to their lowest levels since early March, the U.S. dollar is at its lowest level in a year relative to other major currencies, and the price of a barrel of crude oil ticked higher. Gold continued to climb after breaking through the psychological barrier of $2,000 per ounce, and is trading near all-time highs ($2,060/ounce).

Here are a couple of tidbits that explain the recent risk-on mood:

  • For one, Republicans and Democrats may be “trillions of dollars apart” on a phase four stimulus bill, but for markets, the “T” word is what matters. It seems likely that $1 trillion + in fresh stimulus is coming.
  • On Monday, Alphabet (parent company of Google, YouTube, Waze, etc.) borrowed over $10 billion from investors at record low interest costs. The coupon on the tech giant’s (but not in the Tech sector!) 10-year bonds is a paltry 1.1%. Amazon (another tech giant but not in the Tech sector) set the former record two months ago when their 10-year bonds sold with a coupon of 1.5%. The borrowers’ market extends past just the tech and tech adjacent. Specialty chemical maker Praxair also borrowed for 10 years at a 1.1% coupon. Credit is like oxygen for the economy, and right now investment grade companies are having no problem borrowing money. Same goes for households. U.S. 30-year mortgage rates are close to 3%, near all-time lows.
  • Mickey struck back. Disney’s operating income beat estimates and management commentary was very optimistic. Given that its business model is so reliant on theme parks, movie theaters, and live sports, Disney is seen as a bellweather for economic reopening. While the company took a hit during the worst of lockdowns, positive management commentary for the quarters ahead carries a lot of weight. But don’t forget the digital side: Disney+ now has over 60 million subscribers (as an aside, the subscription is, in our opinion, worth it for Black is King and Baby Yoda alone, not to mention the entire Marvel Cinematic Universe). The stock has risen by +12% since its report on Tuesday afternoon.
  • Finally, and perhaps most importantly, 10-year forward inflation expectations are back above 1.6% for the first time since February 24 (remember: the Fed’s target is around 2%). Meanwhile, nominal 10-year rates are still hovering near 54 basis points (bps). When inflation expectations are rising from low levels, and nominal yields are stable, it implies that growth expectations are rising without the expectation that the Fed will spoil the party with rate hikes. Now that is a true goldilocks scenario for risk assets.

In fact, this dynamic has arguably been the story of the summer. Since Memorial Day, real yields (proxied by U.S. 10-year nominal rates minus 10-year inflation expectations) have dropped by ~60 bps. Here are the returns across asset classes in USD terms over the same time frame. 1

From a broad asset class standpoint, the only way you didn’t make money is if you were in cash. 

How much more can it run? Inflation expectations can only go so far without investors starting to expect some chance that the Fed raises rates. However, the current trend seems clear: an easy Fed, more confidence in the future, and appreciation for risk assets. We should enjoy it while it lasts.

The macro environment is supportive, but the S&P 500 seems to be nearing fair value. That is just an acknowledgement that the market no longer looks “cheap” or is pricing in more risk than it should in the short-term. But these days, if you don’t like the information technology sector, you don’t like the market. It makes up over 25% the S&P 500’s market cap, and is very close to the same proportion of index profits. Spoiler alert: we still like tech for its long-term growth potential, but taking a close look at the sector is critical to understanding the stock market as a whole.

Three key thoughts on the tech sector

The torrid run from the Technology sector has some investors thinking we are living through the 1999-2000 Dot Com euphoria all over again. The sector has returned over 50% in the last year,  flows into technology mutual funds and ETFs are close to all-time highs, and a recent survey from Bank of America found that “secular growth” (which has become a euphemism for tech) is the most crowded trade they have on record. Technology hasn’t outperformed the broad market to this degree since, you guessed it, early 2000. But we still think the sector will lead the market to mid- to high-single-digit returns over the next year. Here are three of our latest thoughts on the Tech sector.

1. Cash flow is king. The story for Tech starts with the big companies like Microsoft and Apple. Both just posted stellar earnings results in the face of one of the steepest recessions on record. Microsoft grew revenue by 13% in the June quarter. Apple “only” managed to grow by 11%. But revenue and earnings do not tell the whole story for those companies, or the Tech sector. Free cash flow does. Over the last 30 years, the Technology sector has changed dramatically. By expanding into software and away from hardware, sales growth has accelerated and volatility has dropped, leading to cash-rich balance sheets and increased shareholder payouts (dividends and share buybacks). Free cash flow margins have expanded from less than 5% in the aftermath of the Dot Com bubble burst to over 22% today (twice that of the market at large).

2. Not cheap, but growth should command a premium. True, the sector trades at a marginal premium to the market on a price-to-earnings basis and price-to-free cash-flow basis. However, investors should factor in growth expectations in their valuation framework. They can do this by looking at the price-to-earnings ratio divided by long-term expected earnings growth (a.k.a. the PEG ratio). This shows how current valuations stack up against growth expectations. On this basis, technology actually trades at a slight discount to the market.  Further, when global growth rates are low (like we expect them to be during this cycle), the segments of the market that are actually growing ought to command a premium. Given this, we expect the tech sector to continue to lead the market.

3. Focus on semiconductors. We like semiconductors as a secular winner. After all, they create the building blocks for digital transformation! Semis also have a cyclical kicker, not only because they benefit from the post-COVID crisis rebound, but also from 18 months of below-trend growth due to trade tensions and supply chain disruptions. Valuations look supportive and continued consolidation (a positive for most industries) could be picking up after the recent deal announcement between Analog Devices and Maxim Integrated. In other areas, software and fintech have tremendous business models at scale, with very high incremental margins. However, valuations have crept above our comfort level in the near term. Whether price or time remedies the overbought nature, we still think long-term investors can find some good individual ideas in the space. Importantly, we are not reliant on valuation expansion for returns. We are focused on finding ideas that can generate positive earnings revisions. Right now, semis seem to provide the best of both worlds, as valuations are undemanding and estimates are likely to be revised upwards.

In short, despite the impressive run of performance, we do not think that current levels in the tech and tech-adjacent space are anything close to a 1999 style bubble. The companies in question have superior balance sheets, superior growth trajectories, and superior free cash flow metrics. To say the least, Microsoft is a higher quality business than

1. It is important to use USD terms in this case because one of the biggest impacts of falling real rates is a weaker USD. This helps the return of ex-U.S. assets for an unhedged USD based investor.


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