The Monthly View – August 2020

Markets have continued to move higher and the Nasdaq has reached new highs while the S&P 500 is at its previous high, increasingly driven higher by surging tech stocks.

The extreme resilience of a few tech titans has resulted in an incredibly concentrated equity market, in which the capitalization of Google, Amazon, Microsoft, Apple and Facebook equals that of 224 other large cap stocks in the S&P 500. Despite the rally of the S&P 500, many stocks are still down significantly since the start of the year as the rally in the Nasdaq and S&P 500 has been driven largely by these mega cap tech stocks.

Such a narrow market raises the following questions:
Is the tech sector in a bubble? If the tech bubble bursts, will the S&P 500 shrug it off or decline with giant technology firms?

Compared to the rest of the market the tech sector is probably in a manic phase. However, this mania has further room to run because inflation will remain low for at least the next two years and global central banks will maintain very easy policy conditions, which will cap the upside in bond yields.

The Pillars of the Tech Sector Remain Intact

The strength of tech stocks reflects both their superior ability to generate cash flow growth and the structural decline in bond yields. It is easy to understand why superior cash flow growth would result in strong tech performance, but the role of lower yields is not obvious.

Tech stocks derive a large proportion of their intrinsic value from long-term deferred earnings and the terminal value of those cash flows. These distant profits are sensitive to fluctuations in the discount rate and, therefore, their present value goes up when bond yields fall. Crucially, easy money and low interest rates will endure for an extended period. As Fed Chair Jerome Powell stated, “We are not even thinking about thinking about raising rates.”

In this context, valuations have room for more expansion. The NASDAQ may be pricey, but it is far from the 1990s’ levels when nominal 10-year yields stood at 6.8% compared with today’s 0.6%. In effect, both the equity risk premium and long-term expected growth rates embedded in tech stocks are much more conservative than in the late 1990s.
In the near term, tech stocks are at risk that earnings that could miss lofty embedded expectations. Also, the U.S. election season introduced new risks as highlighted by President Trump’s banning of TikTok and WeChat and threatening other Chinese tech companies’ access to the U.S. So far, China hasn’t retaliated against these measures but if they do, US tech firms will be hit as well.
The strength of the tech sector will be tested in the coming quarters. Any short-term interruption to the tech mania will also cause a correction in the S&P 500 because the tech sector (including Google, Amazon, Facebook and Netflix) represents 40% of the index’s market capitalization. Without its five largest components (Apple, Microsoft, Amazon, Google and Facebook), the S&P 500 would have increased by only 23% in the past five years instead of its current 54% return.

To add colour to those numbers, these five tech titans have added $4.8 trillion to the S&P 500 market capitalization versus $3.8 trillion added by the other 495 companies.

Despite this risk, we think that any correction in the S&P 500 will find a floor between 2800 and 2900. Some crucial factors underpin equities. Global monetary policy remains extraordinarily accommodative, China is stimulating aggressively, Washington will not let a large fiscal cliff destroy the recovery ahead of a presidential election, and the weaker dollar has a reflationary impact on global economic activity. Additionally, it is likely that the second wave of COVID-19 is less deadly than the first and result in much more limited lockdowns compared with March and April.

Sticking With Our Overweight 12-Month View On Stocks

Despite near-term concerns, we continue to recommend that investors overweight equities on a 12-month horizon. While stocks are not particularly cheap, they are not expensive either. The MSCI All-Country World Index (ACWI) is trading at 18-times calendar 2021 earnings. The forward Price-to-Earnings Ratio (PE) ratio based on projected 2021 earnings is 21 in the US and 15 outside the US.

Even if one allows for the likelihood that earnings estimates are overly optimistic – as they usually are – the earnings yield on stocks is about six percentage points above the real yield on bonds.

Meanwhile, sentiment towards stocks remains downbeat. Bears outnumbered bulls by 12 percentage points in a recent American Association of Individual Investors sentiment poll. On average, bulls have exceeded bears by 8 percentage points in the 33-year history of this survey. Stocks are more likely to go up than down when sentiment is bearish. There is a lot of pent-up demand for financial assets. FOMO (‘fear of missing out’) is replaced by TINA (‘there is no alternative’), which will convince more investors to invest into equities with 10-year yields stuck near 0.6% and short rates at zero.

The world has been turned upside down since February by the coronavirus pandemic. Households all around the globe have been forced to stay indoors; companies have been forced to drastically change working practices; some industries, such as online shopping or videoconferencing software, have seen a surge in demand.
But once the pandemic is over, how many of these changes will stick? What will be the long-term impact on society, the workplace, consumer attitudes, and companies’ strategic planning? How should investors position themselves to take advantage of secular changes in the sectors that will be most affected, ranging from health care and technology, to real estate, retailing, and travel?

Within the next 12-to-18 months, the pandemic will hopefully be a thing of the past, either because a vaccine has been developed, or because enough people have caught it for herd immunity to develop.

This does not mean that people will be unconcerned about a reoccurrence, or about a new virus triggering another epidemic. Pandemics are not rare, even in modern history. And COVID-19 may return as an annual mild seasonal flu (as the 1968 Asian flu did), but which is not serious enough to alter behaviour or the need for social distancing or periodic lockdowns.

Healthcare Innovation

One sector we want to highlight is healthcare as we believe the macro environment for global healthcare equities will remain very positive in the coming years.

An aging population in the world, and a growing middle class in emerging countries will steadily raise demand for health care services. China, in particular, has underinvested in health care: It spends only 5% of GDP, barely higher than it did 20 years ago, and well behind other emerging economies such as Brazil and South Africa.

The health care sector has lagged in the use of technology, in terms of using Artificial Intelligence (AI) for diagnosis, digitalizing patient records, and offering online doctor-patient consultation.

But the use of digital tools had started to increase in recent years, particularly in the number of practices using telemedicine and virtual visits. At the peak of the pandemic in April, the number of telehealth visits in the US rose by 14% year-on-year, compared to a 69% decline in in-person visits to a doctor. It seems likely that this trend will continue, as medical practitioners find virtual consultations more efficient and effective for many simple initial diagnoses, and as sick or elderly patients prefer to avoid a physical visit to a surgery.

The Long View

Looking further out, the outlook for equities is less rosy. Stagflationary pressures could emerge in 2023 or thereabouts as unemployment falls to pre-pandemic levels and supply-side constraints begin to bite. If that were to happen, profit margins would come under pressure, likely sending equities lower.

It is not clear how the US dollar would perform in that environment. On the one hand, a risk-off environment would tend to favour the greenback. On the other hand, if the Fed is perceived as being too slow to tame inflation, the dollar could fall.

Of course, much depends on what is happening in other economies. Exchange rates are relative prices. If inflation rises everywhere, the big winners from higher inflation would not be other currencies, but hard currencies such as gold. That is why investors should consider precious metals and other commodities as a long-term addition to diversified portfolios.

Portfolio Strategy

For now, investors should stick to their long-term strategic allocation despite the possibility of a market correction. Our portfolios have a bias towards large cap quality stocks, which includes and overweight to technology and healthcare, an allocation we believe to be more defensive.