If one was in the business in 1999, try to recall the zeitgeist at that time. It can add some perspective to today's view on the NASDAQ as an index and the technology sector as its underpinning. The buzz was all about using imaginative metrics to back into fair prices for businesses that were generating little to no profits, but where the promise of massive returns "at scale" was the carrot dangled to compensate for the stick of over-valuation risk. Tomes were written about the above-average growth investors should expect as technology continued to become increasingly embedded across all the economic sectors and took an ever larger share of the consumer's wallet. The sell-side did their best to produce thick volumes detailing every internet business ready to be the next Amazon of their category. Analysts rushed to become experts in optical networking and big dreams were dreamed about how steep and high the J-curve was. There are even famous anecdotes about leading astute fund managers getting sucked into long positions in late 1999/early 2000, burdened by the fear of missing out and thereby losing clients, many of whom were and still are quite adept at performance chasing. VIEW was there and it certainly made us realize the power of feelings, especially "fear of missing out". Did succumbing to the emotion and pressures of the day pan out?
How this worked out for buyers (we will naively assume everyone else was smart enough to sell at the top) in 1999/2000 is an easy story to tell. The NASDAQ put in its peak in Q1 2000. In that quarter, the COMP registered an 85.6% yr/yr increase, against an average quarterly y/y change of +14.9%, going back to 1971. To have an idea what sort of spike NASDAQ registered in 2000, consider an 85.6% increase represents a 3 standard deviation move compared to the average, by definition rare. We have found three standard deviation moves should not be ignored but given some thought when allocating capital. Faced with this sort of unusual spike in performance, if one was faced with investing based on forward return assumptions (we think this is generally a good idea), it would seem reasonable to consider the attractiveness of the point of departure, or more plainly, the entry point.
At this point, perma-bulls of technology today will usually devolve into thematic free-form, trotting out phase shifts, VR, artificial intelligence, machine learning, crypto mining, blockchain, Web 3.0, NFT's, IOT, etc. to justify an unyielding long bias to the sector and their view that others "just don't get it". The words were different in 2000 but just as cool in their day. Yet things began to unravel in March 2000 and at a certain point, price action, relative earnings and degree of over-ownership began to matter more than even well-articulated take-offs of "the network is the computer". Maybe even valuation started to matter but probably not in the exact way people think. This said, market ancient history is nice but it might be more helpful if we considered some of the metrics that could have kept investors out of harm's way in the previous blow-off in technology stocks and then consider how some of these signals are flashing today.
Representation in the Broader Market is Full
In fact, NASDAQ did not regain its 2000 peak until Q4 of 2014. Relative to the broader market, an investor really didn't need to own technology from 2000 until the Global Financial Crisis bottomed the market in late 2008. Buyside technology research teams that had run with 7 analysts saw that contract to 3 or 4 over the next decade, as the sector weighting of technology sank from 29.2% in 1999 to 15.3% in 2008. Post GFC, a hand-off crystalized where the trade in energy, basic materials and industrials, that had kicked off with the Chinese WTO entry December 2001, essentially dissolved. Technology began to regain a leadership position driving the market and those investors left standing post 2000 found an audience once again. After all, tech is about innovation and though the leader board may change, the sector should not be ignored for too long. At the end of 2021, technology carried a weight of 29.17%, eerily close to the 29.18% from back in 1999. In fact, it's so close we needed to check it for a typo. Now, the S&P 500 sector composition has had some changes with two large technology companies, Google and Meta, sitting not in technology but in telecom services. Doing the simple math gives us the following:
Weight in S&P 500 1999 2009 2021
Tech+Telecom Svcs 37.1% 23.0% 39.3%
So, the technology ecosystem defined as including services, is now nearly 40% of the entire market and over 200bps higher than in 1999. The last time it reached 37% combined, or just 29% for tech, it retreated, and not by a little but by a full 1400bps. What makes this signal not foolproof is the increased penetration in technology investment relative to total fixed private investment. The average percent spent on technology over the following ten year periods has been:
1980's 1990's 2000's 2010's
15.6% 19.8% 20.4% 22.7%
Source: St. Louis Federal Reserve
This increased importance of technology spending would align well with an increased representation in an index designed to capture the major economic sectors of the economy. While VIEW could be convinced the recent peak should be higher for technology as its representation in investment has risen, it nevertheless remains at a new highest level ever, signal enough for VIEW to conclude this is a headwind for the sector.
There is a Technology Cycle and We Look to Have Passed the Peak
Technology is cyclical, always has been. We would encourage readers to dispense with the labels growth vs cyclical vs cyclical growth. These names merely try to categorize whole industries to static point-in-time silos. We would encourage respect for the cycle and ignore it at your own peril. Check out the semi billings cycle in the first chart below and the total private fixed investment in technology hardware and software in the second. Semiconductors are the essential commodity raw input into computing so it is intuitive that it should exhibit similar cyclical patterns as overall technology spending. The takeaways from these two charts are: that the cycles are clearly visible, we are at the upper bounds of historical y/y increases in spending and cycles in semi billings bottom near or below 0% and aggregate technology investment does so in the mid-single digits. Now, could a countering pressure to the natural forces of the cycle be the large back up in orders due to supply chain disruption? Maybe. But it is also true that there was pull-ahead for orders in the PC supply chain as lock-downs forced communication online and 2020 PC sales showed their first increase since 2014. How much downside in rates of change will doubtless be influenced by overall economic strength, which is showing some signs of weakness in the two recent prints of industrial production and retail sales. We believe corporate margins will also be pressured as 2022 progresses, not usually constructive for increased business spending.
Recent Performance has been Outsized
In the chart immediately above, the NASDAQ/Wilshire 5000 ratio line shows the relative performance since 1980. This is actually what results in the residual weighting of the sector to be so high, i.e. the price performance against the broader market. VIEW likes to go a step further and consider the ratio against the backdrop of a changing long-term average. We do not consider this a pure mean-stable, reverting series but one where over time the mean is dynamic. There are, however, general bounds over the last 40 years that present themselves and the NASDAQ just reached one at the beginning of 2021. While it's performance somewhat stalled on a relative basis in 2021, it remains at the upper end of its relative trading range. At current relative prices, we could forecast a mean 10 year forward relative compound return of -2.3%, not compelling in our view.
All the best for the remainder of January. We will remain keenly intent on watching for cycle and market signals as we move forward.
dar
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