The Rise of Technology Stocks

Anyone interested in Economics or Finance would be aware of the astronomical gains made by Technology stocks in the past few years, particularly those listed on the NASDAQ. The NASDAQ stock market is the world’s second-largest stock exchange, just behind the New York Stock Exchange (NYSE), and is known for its price volatility. Stocks listed on the NASDAQ are concentrated in technology, biotechnology, financial services, media, communications, retail, and transportation.

The FAANG Stocks

When it comes to technology stocks, the most famous amongst them are part of the group commonly referred to by the FAANG acronym – Facebook, Amazon, Apple, Netflix, and Google (Alphabet). Other notable technology stocks in the same league as the FAANG stocks (but not included in the acronym just to keep it short) are Tesla, Nvidia, and Microsoft.

Source – Forbes

The FAANG stocks are renowned for their great returns and market capitalization. Funds have even been established that specifically follow these stocks and other large tech companies on the NASDAQ. At the time of writing, $10,000 total invested into FAANG stocks five years ago would be worth almost $50,000 today, a return of 400%! In comparison, the NYSE Composite (an index tracking the NYSE) delivered a return of 29% over the same period. This can be explained by the societal embrace and trends towards the technologies on offer (Social Media, Online Shopping, Digital Entertainment, Computer Systems, Software, and Communication.)

An example of a FAANG tracking index – Source: Intercontinental Exchange

Furthermore, there is a lot of hype among investors and speculators alike around the 4th Industrial Revolution. Essentially, the 4th Industrial Revolution refers to an ongoing evolution in society and manufacturing to favor mass automation using cyber-physical systems such as artificial intelligence, robotics, the Internet of Things (IoT), and other cutting edge technologies. Buyers of FAANG and other technology stocks hope to capitalize on this trend.

The 4 Industrial Revolutions – Source: Kemp Blog

The 2020 Global Economic Crash

In 2020, the global economy witnessed one of the greatest crashes in history due to the COVID-19 pandemic and uncertainty regarding an oil price war. During March 2020, global markets had declined by approximately 25%. Lockdowns initiated across many nations led investors to fear that many businesses would not survive and unemployment would soar. Furthermore, hospitals would be overloaded with the sick and mass fatalities would be seen, further crippling the workforce.

As most businesses with brick and mortar stores or traditional business models came to a grinding halt during lockdowns, only those that could overcome these constraints could continue to operate and generate revenue. Technology stocks were directly positioned to take advantage of this. A good example is Zoom Video Communications Inc., which is a leading voice and video conferencing software company. With mandatory social distancing in place, business continuity required communication between all employees, and Zoom provided the perfect means for this. Ordinary individuals also used Zoom to connect with friends and loved ones during this period.

Zoom in use for a video conference – Source: The Guardian

The stock price of Zoom rose from $68.04 on the 1st of January 2020 to a peak so far this year of $457.69 on the 1st of September 2020, an increase of almost 7 times. People around the world longed to continue their usual routine and go on with their lives as before, albeit as safely as possible. This led to a surge in online shopping, digital entertainment demand, and online communication. Fortunately, the companies on the NASDAQ and technology stocks were ready and able to meet these needs. During this period, the US Federal Reserve provided the largest economic bailout on record to assist flailing companies and prevent further rout. This act emboldened investors to stick to high returning technology stocks.

Many countries are now over their initial COVID-19 infection peaks, with travel bans lifted and businesses reopening. It would be expected that the demand for technology stocks would then lessen and the stock price would drop as the demand for their service would lessen. However, the opposite has happened and these stocks continued to rally. Seen as a haven from further global economic risk, investors continued to purchase these stocks and the prices continue to rise.

The Problem with Technology Stocks

The price-earnings ratio, also known as the P/E ratio is a ratio between a company’s share price and its earnings per share. This ratio is an excellent rule of thumb used to determine whether a company is overvalued or undervalued. Simplistically, by comparing P/E’s of similar companies, we can determine if a company’s stock is a good buy or not. At the time of writing, companies on the NASDAQ have an average P/E of 35 and in comparison, companies on the NYSE Composite have an average P/E of 21.9.

Source: CFI

Generally speaking, this suggests that technology stocks may be overvalued or investors expect higher earnings in the future. Buyers of high P/E stocks are also more interested in capital gains based on an increasing stock price over time, rather than earnings in the form of dividends. P/E ratios also help investors determine the payback period for their investment. For example, if a company had a share price of $60 and the latest earnings per share was $3, it would take 20 years (Price divided by Earnings) to recoup the share price, assuming constant earnings.

Steins Law was proposed by Herb Stein in 1976 while analyzing economic trends. It states that “if something cannot go on forever, it will stop eventually”. It is suggested that such a process will stop of its own accord if there are limiting external factors. We can apply this law to rising stock prices. These prices cannot keep climbing indefinitely, as a point would eventually reach where their market caps would exceed the total wealth of the world. This cannot happen. By this logic, the exorbitant prices of tech stocks will stop rising eventually – but when?

Source: FinSec Partners

Conclusion

If Stein’s law suggests the technology stocks will stop climbing at some point in the future and the high P/E ratio suggests overvaluation, we can conclude that a stock price correction will soon occur. This correction would result in more realistic P/E ratios and create a speed bump in the stock’s price rise. As of 3rd September 2020, this process began with a minor correction as the NASDAQ fell 6% lower from an all-time high, although a slightly lower drop was experienced in the NYSE Composite on the same day. This suggests a more skeptical economic outlook from investors rather than specifically a decrease in faith in technology stocks. A more reasonable explanation is that investors have chosen to sell their stocks to capitalize on their gains generated over the past year.

I’ll leave you with a quote from Warren Buffet, “Be fearful when others are greedy, and greedy when others are fearful”. Great returns may be reaped during this time but also at great personal risk. As tempting as technology stocks may seem, we must be mindful that what goes up, must come down.

Source: Imgur