Too Big Tech to Fail

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Difficulty: Moderate

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1) Market cap of five US tech stocks > Market cap of top 100 global banks

It used to be that banks were “too big to fail”. Now it’s these five stocks: Microsoft + Apple + Amazon + Alphabet + Facebook.

2) S&P 500 is being supported by the tech sector

Microsoft + Apple + Amazon + Alphabet + Facebook now drive 21% of S&P 500. Their positive share price performance has supported S&P 500 index levels, and their expected earnings growth is also propping up S&P 500 earnings estimates. Meanwhile, the rest of the S&P 500 isn’t expected to do as well.

3) IQ wouldn’t buy stocks right now

On the basis that current tech valuations are unsustainable and that 2Q tech earnings estimates are overly optimistic. While the proportion of online ads to traditional ads has increased during Covid, the overall budget for ads is shrinking fast with multiple industries hit by the effects of social distancing.

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Banks were “too big to fail”…

Mega banks, mega banks, mega banks…. Having lived through the 2008-09 crisis, and having just watched the Netflix’s Dirty Money episode on Wells Fargo getting a cursory slap on the wrist for corporate wrongdoing, I find it hard to fathom the size and influence that mega banks wield…

But US banks no longer carry the same clout that they used to. The above chart shows the % weight of the Financial Sector within the S&P 500 Index since 2000. It peaked in 2007 before declining steeply with the systemic banking crisis. The banking sector never did see its pre-crisis golden age again. Newly hired graduates no longer travel to their month-long New York training programs on business class seats (they now settle for economy class) and bonuses are now measured in months instead of years… (the audacity!)

Especially as we head into the next recession. Given the cyclical nature of bank stocks, no surprise that the sector experienced a massive sell off year-to-date and we now see the Financials Sector’s proportion within the S&P 500 nearing 2009 lows. So if it’s not the mega banks driving the S&P 500 now, what is?

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Now, it’s about Big Tech

It’s really about these 5 tech stocks. Just when you thought buying the S&P 500 Index gave you diversified exposure across 500 stocks…you wake up to find out that Microsoft + Apple + Amazon + Alphabet + Facebook drives 21% of the Index. And this isn’t even the tech-heavy Nasdaq Composite…

5 tech stocks vs. 100 banks? For context, the combined market cap of these five US tech stocks has grown larger than the combined market cap of the largest 100 global banks, as you can see in the below table.

Analysts have been recommending a switch to Tech stocks. When the sell-off first started with high yield credit spreads widening through March, everyone’s immediate reaction was to trim stocks (industrial, financial and energy sectors come to mind) with weaker balance sheets, heavily financed by debt and facing potential refinancing / liquidity risk. There was a large consensus among bank analysts, advising clients to re-position into big tech, companies that were operationally less impacted by the lockdowns and held huge net cash positions to weather out the storm.

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Only the tech sector has posted a positive return year-to-date

Surprise…! As a result, the tech sector has unbelievably returned a positive return for the year, with forward Price/Earnings now at 24x, nearing the highest levels since the dotcom bubble (chart below). This is likely the reason why the S&P 500 appears so resilient, despite us heading into possibly the worst recession since the Great Depression.

What’s happening to other sectors? The headline performance of -10.7% for the S&P 500 Index this year hides the actual pain that corporate America is facing. If we look at the median stock performance of the S&P 500 Index or the median performance within each sector, you see a much lower return year-to-date. The logical inference is that small/mid-sized companies are facing a much tougher time, with much less financial and/or operational capability to weather out this crisis.

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S&P 500 is being supported by the tech sector

My view is that the S&P 500 will be largely dependent on the tech sector. Tech has grown to become the largest sector within the S&P 500, comprising 26% of the Index, so any sector moves will have a proportionately larger Index impact.

Inflows now, higher risk of outflows later…? The tech sector has also seen sizable inflows this year, with the largest two US Tech ETFs recording almost US$3bn of net purchases year-to-date (chart below). Consequently, the sector faces higher risk should there be an unwinding of positions.

Analysts remain optimistic. Revisiting the largest five stocks within the S&P 500, consensus remains largely optimistic, with implied price upsides of 3-13% to average broker target prices.

Projected earnings growth is being supported by these five stocks. From a Goldman Sachs report published 1st May (table below), it implied that earnings growth for the S&P 500 Index is going to depend almost entirely on these five stocks, with the five stocks generating an estimated annualized earnings growth of 12% vs 2% from the remaining 495 stocks between 2019-2021.

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The InvestQuest View

The InvestQuest View: So should we buy stocks now? In my view, the answer would be no. I believe that current tech valuations are not sustainable and that 2Q consensus estimates for tech are overly optimistic. While the proportion of online ads to traditional ads has increased during Covid, the overall budget for ads is shrinking fast with multiple industries hit by the effects of social distancing.