"Kee Points" with Jim Kee, Ph.D.

Is this a repeat of the tech bubble and bust? If you follow markets you know that last week ended with the sell-off of several big name technology stocks including Apple (down 3.9%), Facebook (down 3.3%), Alphabet (down 3.4%), Amazon (down 3.2%), and Microsoft (down 2.3%). Barron’s points out that, over the past six months, just these five stocks alone had increased in value by $600 billion, equal to the combined GDP of both Hong Kong and South Africa. The tech heavy NASDAQ index was down 1.8%, while the Dow Jones Industrial average finished at a fresh all-time high. The sell-off in the technology sector has drawn comparisons to the late 1990s technology bubble, but I wouldn’t go that far. Technology was up over 16% year-to-date, so a pullback shouldn’t be that surprising. And the tech bubble itself is a little misunderstood. Technology stocks are often about the future, somewhat like looking through a telescope rather than a microscope, and the market prices in estimates of future sales and profitability. Based upon my experience as a portfolio consultant during the late 1990s, what made that market so implausible was not the fact that individual companies couldn’t possibly hit the expected growth forecasts priced into them. The implausible part was that all (well, hundreds) companies were priced to grow at 25%+ annual rates for the foreseeable future (by contrast, the economy was only growing at 3%-4%).


A company growing at 25% per year triples in size in five years. That’s not unheard of, but expecting many companies in an entire sector triple in size is implausible, and that’s what you saw in the technology sector during the late 1990s tech boom and bust. Bubbles occur when expectations that are plausible for a single company get priced into all companies within the same broad economic sector. This is reflected in studies by McKinsey and Company, which show that overall stock market bubbles and even company-specific bubbles are actually quite rare. It is sector bubbles that are the most common. Thinking about this a little more deeply, UCLA economist Arnold Harberger, in his 1998 presidential address to the American Economic Association, argued that real disruptive innovation occurs at the company level and is sporadic, like mushrooms popping up, rather than occurring evenly across industries, like yeast spreading. Harberger documented this decade-by-decade beginning in the 1920s. The takeaway for investors is to beware of instances where the market is pricing in sector-wide expectations for growth, i.e. spreading like yeast rather than mushrooms. That’s how bubbles are made. Inflated expectations at the sector level occur with some frequency (e.g. technology, financials, energy, etc.), which is why having a discipline of controlling or capping sector exposure is so important.


So I don’t think that the current run-up in the FAAMG stocks (or FAANG if you replace Microsoft with Netflix) is a replay of the tech crash. I think they might have gotten a little ahead of themselves, but then the market overall has been pretty optimistic, with the S&P 500 running at an annualized rate (if you assumed the rate of increase so far this year for the whole year) of 16.5%, the Dow Jones Industrial average at 20%, and the NASDAQ at 30%. Corporate profits are improving, but I’d say that’s also pricing in some pretty strong expectations for corporate tax and regulatory reform! For some context, the NASDAQ at 6150 is only about 22% above it’s tech boom peak of 5048 (achieved in March of 2000), which was over 17 years ago. The trailing price-to-earnings ratio at that time was over 100, versus today’s 26 (and earnings are accelerating), meaning the NASDAQ was about 4 times more expensive in 2000 than it is today. Pullbacks and corrections should be expected, they just can’t be predicted. And “taking money off the table” during sell-offs greatly increases your chances of being out of the market during the handful of days that make up a disproportionately large share of long-term gains.


Another interesting point in the weekend Barron’s was a discussion regarding the impact of technology on company profitability, as measured by return-on-investment (ROI). ROIs are a product of operating margins and asset efficiency or (asset “turns”). It sounds complicated but it is actually pretty intuitive if you think about it in terms of running your own business. For example, if you sell pizzas for a living, you make money by either charging a lot for each pizza (high margins), or by selling a lot of pizzas every year (high asset efficiency but lower margins). Technology can help to improve margins by substituting for labor, for example by using automated online ordering instead of having someone taking orders over the phone. And you can also substitute technology for assets like brick and mortar, (improving asset efficiency) which is most obvious in retailing where online shopping takes the place of foot traffic in stores. This impact of technology on business efficiency certainly helps to explain the growth and profitability of the technology sector beyond just smart phones and similar consumer devices.