Could a new ‘tech wreck’ spread?

US technology stocks have been smashed … but there is no narrative.

Summary: The dot-com crash in 2000 sent shockwaves across stockmarkets around the globe. Over the last week US markets suffered a mini meltdown as technology stocks were sold. But what was behind the sell-off, and should investors be fearing another tech wreck – one that would cause a major market drop in Australia?
Key take-out: Market volatility is par for the equities course, but the market’s volatility index is currently low. That suggests that, overall, traders are not overly concerned by recent developments. Technology stocks are trading well below the average P/E levels recorded in 2000, and there is no narrative around the US sell-down activity. Heavy computer-driven trading is the best explanation.
Key beneficiaries: General investors. Category: Shares.

We know that we’re not facing another tech wreck.  We saw that in James Kirby’s piece last week (Navigating the tech stock maze).

As Alex Barbi, fund manager at the Sydney-based Platinum International Technology Fund, said: “I don’t think we are in that situation we faced in the dot-com times. I’ll give you a simple piece of evidence if you go back to the dot-com boom, a key company such as Cisco was trading on a P/E of 120 times. Today we have Facebook, one of the most highly prized companies in the sector, trading on 37 times. I think that should put it in perspective.”

That’s a very good point, and I would concur. During the dot-com period back in 1998 the Nasdaq rose by more than 200% in the space of about 18 months (133%pa) to a record high of 5132 (intra-day). The speed at which the index rose should have given, and did give, many warning that not all was well. The same index subsequently crashed, giving all those gains back and ending lower than when the boom began.

In 2014, we find that the Nasdaq is up ‘only’ 32% over the last 18 months (21%pa) – nothing too excessive about that. Looking at the price action longer term, we see that since a low in 2009, the Nasdaq is up about 200% or more. But that’s a gain over five years – 40% per year. That’s a lot, don’t get me wrong, but it’s well below the pace we saw in the lead-up to the tech wreck.

That said, there is something going on. Last week we saw stocks fall in five of the last seven sessions. Falls were heavy in some cases, with the Nasdaq losing more than 3% in one session. This was the biggest fall in nearly three years. Obviously, it doesn’t have to be actually a tech wreck for our investments to take a substantial hit. A largish correction would suffice, if it spread, noting that the All Ordinaries index is flat (thereabouts) so far.

At this point though, the Nasdaq is only down about 8% since a recent peak in February. The broader S&P500 is also down in five of the last seven sessions – but only 4% from peak to trough. Australia’s market, in contrast, is roughly flat – this outperformance probably due to the fact that we’re an ‘old economy’.

So where to from here?

The fact that Australia is regarded as an old economy means that we don’t need to be overly worried by our market collapsing if there is a major correction, confined to the tech space. Having said that, our market wasn’t entirely spared from the dot-com bust. The All Ords effectively did nothing during the following three years – investors would have been better off in other investments. Consequently, while we don’t need to be overly worried, we need to be alert. We need to know the likelihood of this latest tech rout spreading and, if so, how bad it might get.

Backtracking a little, we already have it from Alex Barbi last week that earnings multiples now (on the Nasdaq) are nowhere near where they were during the dot-com boom. In spite of that though, there is a widespread view that tech stocks are still expensive, that valuations are stretched. What’s interesting about that is the apparent lack of supporting evidence. Indeed, there doesn’t appear to be much evidence at all, as the fact is the Nasdaq isn’t all that expensive. See chart 2 below.

As you can see from the chart, the Nasdaq’s earnings multiple, while high relative to the last few years, isn’t high relative to a longer time period. In fact it’s around the average, although in this instance the average may not be a useful measure of central tendency (the range is quite wide at 17-56). My point is, though, that a multiple of 34 isn’t that threatening – especially on a forward basis, with the one-year forward price-earnings ratio even less threatening at around 19.

That fact alone strongly suggests that the current tech rout isn’t going to spread very far, and indeed may not last very long. Remember, for any great correction, you need a narrative. There has to be one; markets don’t just correct for no reason. If tech isn’t expensive, then what?  What’s going to be the catalyst that will see markets tank?

  • It’ not a weak economy, as the US economy is accelerating and retail sales just this week showed consumer spending surging.
  • It’s not a lack of liquidity. The US printing presses are still running hot and policymakers are promising ultra-low rates for a very long time.
  • Moreover, and as I discussed last week, it’s unlikely to be the May seasonality kicking in.

That doesn’t leave a lot – the Ukraine maybe, and the so-called ‘unknown, unknowns’. With that in mind, it’s my view that this current sell-off is primarily driven by computer driven algorithmic trading. This is something which has received a lot of press lately, but has in fact been a key driver of many markets for at least a decade. Estimates vary, depending on the source, but most attribute 50-70% of stock trades in the US to computer algorithms or ‘Algo’ trading, as it’s sometimes called (which includes high frequency trading).  Now, the thing is, computer algorithms don’t trade a view. They’re not pessimists or optimists. Long or short, it doesn’t matter. If they’re not front-running trades – like high frequency traders do – then algorithms trawl through the media to determine sentiment, trading off headlines, or test bid-offers to try and determine which direction it is easier to push a price.

Algos can only take things so far, unless they can spark a panic. But this is very difficult to do without a narrative. A ‘Grexit’, for instance – recall those economists stating as fact there was a 95% chance Greece would leave the Eurozone in 2010 or 11.

Even during the dot-com bubble there were narratives – Y2K being one. The world was ending and corporates would have to spend big on IT to prevent Armageddon (I have to confess to filling up my fuel tank the day before). Without that narrative, this should calm down quite quickly. That the VIX (an index which measures market anxiety – the higher the index the more worried markets are) is so low also suggests things will calm down. This index currently tells you there are few concerns in the market – there is no narrative at this point. If there was, volatility would be markedly higher and a case could be built that a big broad-based correction was looming. With what we know now, that doesn’t look likely.