The Case For Tech’s Infinity Rally

If you’ve taken anything away from recent discussions in these pages around tech’s resilience in the face of the COVID panic, it should be that the sector (or at least the heavyweights) is the main beneficiary of what amounts to a perpetual motion machine dynamic, and that in many respects, the crisis threw that machine into high-gear.

Admittedly, quoting Howard Marks’s 2017 essay on this subject is a bit cliché three years on, but it’s one of his better expositions, and I feel like it’s becoming more relevant all the time. “The large positions occupied by the top recent performers — with their swollen market caps — mean that as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise”, Marks said years ago, adding that “in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because it’s overpriced”.

Earlier this week, I ventured that the combination of that dynamic with the proliferation of smart beta products, “factor crowding”, and a macro environment that perpetuates this self-referential loop (as the slow-flation world pushes bond yields lower to the benefit of the duration trade), has created “peak perpetual motion”.

Read more: Robinhood, Mega-Cap Mania, And Peak Perpetual Motion

In the same post (linked above) I emphasized that this is now accelerated even further by the assumed upside for the trade in a post-COVID reality where tech companies control nearly all types of commerce and increasingly define the contours of social interaction.

In retrospect, I suppose there’s something absurd about the concept of “peak perpetual motion”. After all, if it’s truly an unstoppable self-fulfilling dynamic, there is no “peak” – it will go on for the foreseeable future by very definition. It’s an “infinity” trade.

SocGen’s Albert Edwards (jokingly/sarcastically) made reference to this in his latest note. If the perpetual motion machine dynamic continues to mean that large-cap indices are essentially just “FAAMG plus some other stuff”, and those names benefit not just from expected shifts in consumer behavior and social interaction following the pandemic, but also from the broader macro trend wherein, all efforts to stimulate aside, bond yields continue to trend lower as policymakers are unable to generate robust, sustainable growth/inflation outcomes, well then “why can’t the S&P carry on rising in line with falling bond yields?”, Albert asked.

Again, he was kidding, but he raises an important point. And while scanning the latest global equity outlook from Credit Suisse (which spans a truly daunting 126 pages), I ran across some commentary from the bank which speaks to all of the above in very concise (and incisive) terms.

On the heels of the surge off the March nadir, Credit Suisse keeps the US at benchmark in their allocation for a variety of reasons, including that tech is nearly 40% of US market cap.

(Credit Suisse)

In a comparatively brief section explaining why they remain overweight tech in general, the bank begins by noting that “if the economic downturn is worse than expected, we would expect to see accelerated digitalization and the defensive merits of tech rising to the fore”. “Net cash on the balance sheet, technology is used to deflation, hardware has a short product cycle enabling quick right-sizing, and most tech products enable cost-cutting”, they go on write, before stating the obvious, which is that “the virus is accelerating the use of the online economy”.

That’s the straightforward, simple case. But there’s more.

“If the world recovers in line with our house view, then we think inflation expectations would rise, but critically central banks we think would cap bond yields”, they go on to say. Indeed, central banks have to cap bond yields, given the necessity of accommodating massive issuance from governments implementing trillions in fiscal stimulus.

Now, consider that, as Credit Suisse goes on to say, capping yields “would allow the discount rate (in real terms) to fall as the TIPS yield goes [negative], hence favoring long-duration assets”. As I’ve pounded the table on for years, the rally in secular growth and tech (at the expense of cyclicals, value, etc.) is in no small part just a manifestation of the vaunted “duration infatuation” in rates.

Closing the loop (and this is critical), Credit Suisse writes the following:

We also believe that tech is cyclical, with both capex and opex being part of corporate spend so that 1% on GDP is around 2% on tech investment. Thus as we have argued for some time, tech is a cyclical, defensive and growth sector. There is little sign of excess investment in tech, in our view.

It’s factor crowding, only justified. That is, maybe tech really is synonymous with multiple factors, and given that money will continue to flow into the space as it outperforms, that buying will tend to push volatility lower, making it akin to min. vol., too.

So, what about valuations? Aren’t they absurd? Maybe. But maybe not.

“While tech is very overbought, its valuation is not yet unreasonable, in our view”, Credit Suisse goes on to say, adding that the relative P/E is “far below its pre-bubble valuation”

(Credit Suisse)

Summing up their view on the space, Credit Suisse says that “in the long run, we believe that the fall in the discount rate could drive tech+ to ‘Nifty 50’-type valuations”, where that means “45x P/E compared to 31x currently”.

Does any of that mean the bank doesn’t recognize the peril of market concentration in the S&P 500, where just five names comprise 21% of market cap? In a word: No. In fact, the bank readily calls that statistic out and identifies it as a red flag.

(Credit Suisse)

“Whilst we are still overweight tech globally, the extraordinary concentration in the US market still worries us”, they write.

And yet, as I never tire of pointing out, there is a reason why this state of affairs looks like it does. This isn’t all down to the perpetual motion machine. The following chart (which I employ at least three times per week), shows that, generally speaking, there’s just no growth expected outside of these names.

More generally, Credit Suisse’s outlook for US equities isn’t entirely sanguine. The bank warns, for example, that “the risk of corporate deleveraging is higher in the US than elsewhere and… there is a clear risk that this alters the funds flow, with corporates being the major buyer of equities and buybacks accounting for c30% of EPS growth since 2012”.

As documented here, that supply/demand equation is about to be flipped on its head, with corporates shifting from buyers to sellers.

[Editor’s note: Clearly, the title is in jest. Nothing can go up in a straight line forever, and no bank that I’m aware of would ever suggest as much – or at least not explicitly]


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9 thoughts on “The Case For Tech’s Infinity Rally

  1. On one side, the idea that forced acquisition of the top tech stocks by large passive fund managers is a compelling theory. Fundamentals don’t seem to be a real factor … yet. However, increasing the enforced political isolation of the US as practiced by the current administration may be a threat that can break that cycle. Apple needs both the demand and the supply chain of a relationship with China. A lot of the revenue from Amazon is dependent on cheap imported goods. While being cut off from the rest of the world may not be an existential risk, it can really threaten the growth that make the tech giants such high momentum stocks. It is possible to break something that seems unbreakable. Finally, the math is against the infinity machine. Growth by any company at rates above the growth in the overall economy implies the survival of only one company at some point. That seems doubtful.

  2. I think I get the case for the current valuations of FAAMG. I don’t agree with it, but I do recognise its plausibility. I also get the case for ‘the other stuff’ being fairly valued. Where I come unstuck is trying to hold both arguments simultaneously. Either the digital behemoths go on to utterly dominate our lives, and ruin much of the remainder of corporate America, or they don’t. In that regard, the parallels with the 90s tech valuations are quite strong. In those days there was an underlying, if somewhat underappreciated, presumption that the ‘new economy’ was somehow additive to the traditional economy rather than substitutive for it. Eventually people realised that was nonsense.

  3. Does it seem as if there is a growing capitulation to the idea that it is foolhardy to stand in the way of US mega tech as they morph into an all-weather status asset?

  4. I follow the strategy of the tech companies and it may be that the market on the outside is valuing them differently than what they really are… and of course lumping all of “tech” together is naive…
    – Uber/Lyft/AirBnB etc are the “sharing economy” which touches the physical, they got hammered, never even clear how they got profitable (at least to match valuations)
    – Google has almost run out of ways to artificially squeeze ads into search (basically 95% of revenue), have more of an “umbrella company” approach with long bets like Waymo, Verily, etc and are under regulatory scrutiny … FB ditto (milking Instagram) and Libra … both have not managed to crack selling hardware (or anything else besides Ads), they’re almost a Duopoly in advertising and tracking but no “magic growth sauce”
    – Apple has won the smartphone/device market (for Google it’s a sideshow data vacuum, it’s a tiny piece of the megacorp Samsung ), they’re dependent on the global economy (and their slow shift into Service/Subscription)… basically China… to see significant growth as a 39 year old hardware company
    – Microsoft have rejuvenated really well: they’re targeting Cloud, Developers (github, npm, etc), to continue being #1 for Business (with a taste of consumer via Xbox and Surface), I’m unsure who values a 45 year old company as a “tech disruptor growth bet”
    – Amazon is eating everything, unclear if there’ll be a mis-step (only big markets like Healthcare, Fashion, etc remain to make a difference in growth)
    – Netflix borrow like crazy, but as Quibi proved even billions of dollars doesn’t count, so it’s probably a growth stock (if you see their crazy good analytics/algorithms, global numbers and vertical integration for content as a huge moat); hyper focused on their one business (and they have “Ads” as a fallback revenue stream at some point in the future) , of course I don’t own NFLX because PE of 85 for “shows” seems crazy =p

    So to echo the article, people (or algos?) invest in FAANMG because they’re the new Ford and IBM, but do it at crazy valuations because ZIRP (and the herd crowding at the watering hole can’t be wrong, right?)

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