Booms and busts follow a pattern. They start with a change in economic fundamentals, and that change trickles down to financial markets. Businesses start with hedging activities that transform into reasonable profit-making activities and then ultimately to speculative activities. This is where the bubble busts!
In our article “Is Another ‘Dot-Com’ Bubble Coming?” published last month, we looked at VC investment activity, the trend in broader stock market performance taking the Nasdaq as a proxy, and the slowdown in the U.S. housing market. We also concluded that another dot-com bubble may be coming very soon.
At present, we feel that the prologue has already begun and the stage is set for another dot-com scenario. And this time, the impact could be far severe. The world is becoming increasingly digital and tech firms are now so big and so extravagant that a slowdown could devolve into economic turmoil.
To provide assertion to our claim, we delve a bit deeper into our broader stock market analysis and look specifically at the trend in the technology sector. A closer look at the overall tech stocks comprising the S&P 500 shows a 45% decline from the peak observed in late January 2018. Going into the finer details, we see that over two-thirds of this decline actually occurred within the last three months – an index price of 79.21 on August 7 versus 51.51 on November 6!
Since 2013, around 37% of the rise in the value of all firms in the S&P 500 can be attributed to six of its constituents: Alphabet, Amazon, Apple, Facebook, Microsoft and Netflix. And the trend is not specific to the U.S. firms. Two firms alone – Alibaba and Tencent – have contributed to 28% of the rise in Chinese equities over the same period.
The recent IPO of Xiaomi, the largest tech listing of 2018 registered in Hong Kong, has suffered the same fate as the aforementioned tech stocks in the US and China. Subscription price at the time of its IPO in July 2018 was $ 2.17, which rose to a peak of $ 2.75 – a gain of 27%. However, today, the stock is trading at $ 1.70 – a decline of 38% from the peak.
Signs of this negativity spreading to the wider economy can be gauged by the impact on share prices of firms that are big investors in tech companies. According to an analysis by the Economist, Naspers, the most valuable African firm, has witnessed a 38% decline from its peak due mainly to its large stake in Tencent. Likewise, Scottish Mortgage, a FTSE 100 investment trust, has witnessed an 18% decline due to being bullish on tech stocks.
While the recent rise in real interest rates has had a fair share of detrimental impact on these tech stock prices, its contribution is limited to circa 30% as per a discounted cash flow analysis by the Economist. So where is the remaining 70% of the decline coming from? There are arguably three contributing factors.
Slowdown in expected revenue growth. For example, the mid-point for Amazon’s expected sales growth for the fourth quarter of 2018 is 15%, a steep decline versus the 31% growth rate observed in the first quarter. This is despite the fact that consumer spending tends to be high in the fourth quarter of every year because of the holiday season.
Fall in profitability expectations. Naturally, the slowdown in revenue growth is having a trickle-down effect on profitability. Particularly, projections for Facebook have sunk by 18% and those for Netflix by 11%.
Rise in capital intensity. As the number of consumers remain limited, firms have now started to compete over e-commerce, entertainment and payments. In other words, this essentially means consumer growth has stagnated within a firm’s particular category. Amazon moving into advertising and Apple into video is putting pressure on margins, as growth is no longer exponential. Moreover, these firms are sitting on large piles of cash on their balance sheet, which indicates lack of availability of high margin, viable investment avenues. Apple’s cash on hand was at a record $285 billion at end of 2017.
So what now, you ask?
It would be wise to start switching to defense mode. Increase your exposure to large non-tech firms with strong balance sheets, particularly those in the consumer goods sector where demand for their produce is relatively inelastic. Couple this with a bit of government bonds or non-tech investment grade corporate bonds to keep that income flowing.