“It’s Enough To Make You Miss The Dotcom Bubble”: Why The US Stock Market's A Threat To Your Passive Investments

“It’s Enough To Make You Miss The Dotcom Bubble”: Why The US Stock Market's A Threat To Your Passive Investments
Reda Farran, CFA

over 3 years ago4 mins

Mentioned in story

What’s going on here?

The S&P 500 index of the US’s 500 largest public companies is perhaps the most important stock index in the world. With over $10 trillion tracking or otherwise tied to the S&P 500’s value, its composition is of great importance to active and passive investors alike. But with almost a quarter of the index concentrated in a handful of big tech stocks, people may be taking on more risk than they realize.

What does this mean?

It’s no secret that the tech sector has led the market rebound from March’s pandemic-induced lows. And it’s somewhat understandable. For starters, tech firms have profited from a locked-down world in which everyone works, shops, and socializes from home. Our doorways are filled with Amazon packages and our screens by Netflix shows or Facebook-owned chat platforms, while those still in employment collaborate remotely online via Microsoft and Google services.

What’s more, most of these tech companies have plenty of cash and not much debt, making them safer bets in the face of an economic downturn. And with central banks around the world slashing interest rates this year in response, the present value of tech firms’ future earnings has increased. Finally, an emerging generation of retail investors (think Robinhood users) has concentrated on tech stocks, often through the use of leveraged call options (as also favored by Japanese conglomerate SoftBank).

The upshot is that tech share prices have massively outperformed the average US stock this year. The S&P 500’s five largest companies – Apple, Microsoft, Google parent Alphabet, Amazon, and Facebook – now represent almost a quarter of the index’s total market value. As shown below, this is an even higher level of concentration than at the peak of the tech-tastic dotcom bubble.

S&P 500 weighting of top.5 stocks
Source: Strategas Research Partners

Why should I care?

The S&P 500 looks increasingly like a “core-satellite” portfolio – where the core is the wider US market, and the satellite a concentrated bet on just five tech stocks. With those $10 trillion of assets benchmarked or indexed to the S&P 500, such a situation is problematic for both active and passive investors.

Professional fund managers who measure success against the S&P 500 have no choice but to own these stocks. If they don’t, then they’re taking a massive underweight bet relative to their benchmark – and if the tech stocks continue to outperform, then that could cost them their job. To avoid this career risk, money managers end up buying the top holdings in their benchmarks just to be safe – further fueling the largest stocks’ rally.

Passive investors who purchase exchange-traded funds (ETFs) tracking the S&P 500’s performance also have to watch out for risks. What happens to those heavyweight tech stocks in a scenario where a successful coronavirus vaccine helps reopen the global economy? Separate breakthroughs from pharma firms Pfizer and Moderna recently led to large stock market “rotations” in which investors dumped expensive tech stocks and bought economically sensitive “cyclicals” such as banks, airlines, and hotels instead.

The graph below shows how the valuation multiples of Apple, Microsoft, Alphabet, and Facebook have all expanded this year, with their price-to-earnings (P/E) ratios showing stocks worth around 30x next year’s projected profits. Amazon’s (not shown) is currently 80x. Taken together, these five firms have an average P/E ratio of 40x – double that of the average S&P 500 stock.

P/E ratios of tech stocks
Source: Koyfin

With valuations this high, are tech investors being properly compensated for potential risks? The big one is regulation. Apple, Amazon, Google, and Facebook are facing numerous probes on both sides of the Atlantic into allegations of unfair dominance. A mild outcome could see stronger checks on monopolistic practices; in an extreme one, these firms could be broken up. That’s not to mention ongoing scrutiny over privacy issues, political interference, and taxes. The European Union, for example, is trying to hit tech companies with a digital services levy that could seriously dent their profits.

So what’s an investor to do? If a large proportion of your portfolio is in an ETF or index fund tracking the S&P 500 – and especially if you own individual stakes in tech stocks on top of that – be wary of the fact that you’re doubling down on an expensive area just when tech is at risk of underperformance due to a vaccine-induced market rotation and regulatory intervention. If you do want exposure to the US stock market, consider switching to an ETF such as RSP – which tracks the equal-weighted version of the S&P 500 index. Not only could this help you avoid over-concentration in tech stocks, but such ETFs also trade at a 20% lower P/E ratio than SPY – which tracks the standard S&P 500.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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