Echoes of the past often ricochet around markets to inform the present. So, for longtime market watchers, it’s difficult not to see parallels between frothier parts of the technology sector and the dot-com boom.
Current conditions are still some way off the mania of 1999, when the tech-heavy Nasdaq Composite Index powered ahead almost 90 per cent before the big bust in 2000.
But there are more than a few trends in markets that chime with those bubble times. In the past two years alone, the Nasdaq Composite Index has recorded back to back annual gains in the region of 40 per cent.
Retail investor buying of tech stocks may not be quite at dot-com-mania levels. However, the dizzying ascent of companies such as Tesla Inc. (TSLA-Q) shows that many investors are willing to put aside doubts on business models to bet on the promise of innovation in energy, health care, robotics and artificial intelligence.
One manifestation of that fervour is the extraordinary rise of Ark Investment Management LLC’s exchange-traded funds (ETFs) focused on companies promising tech disruption.
With big holdings in stocks such as Tesla, the flagship Ark Disruptive Innovation ETF, managed by Cathie Wood, delivered a blockbuster gain of 150 per cent in 2020. Ark’s Genomic Revolution ETF was up 180 per cent in the same period. Both have gained a further 17 per cent in 2021. After big inflows, Ark now ranks in the top 10 issuers of ETFs by size, with US$41-billion under management, according to Bloomberg data.
The inflows have drawn comparisons with the famous Janus Twenty Fund that was the trailblazer of the dot-com boom. In early 2000, at the peak of the bubble, half the money pouring into mutual funds from investors went to Janus Capital Group Inc. before it suffered badly in the dot-com bust. Scott Schoelzel, former manager of Janus Twenty Fund, recently told Bloomberg that Ark’s approach was similar to his own back in the early 2000s.
However, current market valuations have raised skepticism.
“Exchange-traded funds focused on tech innovation and green energy are full of companies that are losing money and have high [valuation] multiples,” says Andrew Slimmon, portfolio manager at Morgan Stanley Investment Management.
Some of the frothier areas of tech today remind him of the late 1990s. “Valuations got to an extreme and they couldn’t live up to expectations and the losses were painful,” he says.
In broad terms, Nasdaq valuations are less inflated now than back in 2000. But a harsh lesson from manias is that paying a premium for the future promise of tech can leave you suffering buyers’ remorse for a long time.
There are some important differences between today’s tech stocks and those from the past. They are more focused on software with steadier earnings from subscription models. They have also benefited from widespread shifts to digital services arising from the pandemic.
Their earnings growth is so consistently strong – especially in the case of Amazon.com Inc. (AMZN-Q), Facebook Inc. (FB-Q), Microsoft Corp. (MSFT-Q) and Alphabet Inc. (GOOGL-Q) – that they are seen as quality investment plays. They have prospered from a pronounced decline in long maturity interest rates as well, which has boosted the relative value of their fast-growing, future cash flows.
Larry McDonald, a former bond trader and founder of the Bear Traps Report, argued that “tech stocks are more like long-dated bonds,” meaning their valuation will suffer should interest rates and inflation rise sharply. “Half of Nasdaq is like the speculative plays we saw in 1999, while the other half is more exposed to interest rate risk,” he says.
Investment manias powered by cheap money typically end when financial conditions become tighter via higher interest rates. In 1999, the U.S. Federal Reserve Board was worried about Y2K, a flaw in the way computers processed dates seen as creating havoc once 2000 dawned. After flooding the financial system with cash, the central bank then began withdrawing that support and raised interest rates.
Two decades later, the focus among investors is once again on the timing of monetary support retreating. After lagging behind the broader market during the final quarter of 2020, tech stocks have seen share prices fall so far this year as the 10-year Treasury yield has risen beyond 1 per cent.
Investors including Jeffrey Gundlach at DoubleLine Capital LP highlight an early warning sign in the struggles of the Nasdaq 100 to stay above its peak relative to the S&P 500 from 2000.
The ideal rate scenario for tech is if the Fed tolerates a slow rise in 10-year yields as the economy rebounds. The aim would be to let the air out of the more speculative areas while strong earnings for other tech companies limit selling pressure elsewhere.
“Bursting the mania in areas of tech while keeping the stock market largely intact would be a perfect scenario for the Fed,” says Dhaval Joshi, chief strategist at BCA Research Inc. “But controlled outcomes are usually very difficult to achieve when markets are fragile.”
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