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”.
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.
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”
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.
“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]