In spite of high valuations, weakening global growth and lacklustre corporate earnings, 2019 was another buoyant year for the US stock market. It delivered its best performance in six years, led by a small number of dominant global technology companies – the FAAMGs (Facebook, Apple, Amazon, Microsoft and Google). However, this introduces some real risks to the continued strength of the US market.
The rise of the FAAMGs mirrors a number of the major asset bubble over the past fifty years. Stock prices in the FAAMGs group have increased more than 7 times in the last decade (1), rivalling the Nikkei boom in the 1980s, the Nasdaq boom in the 1990s and the price of crude oil in the 2000s. Only the rise of gold in the 1970s meaningfully outpaces their current growth.
Apple and Microsoft have a combined market capitalisation of $2.1 trillion, more than all the companies in the UK FTSE 100 combined. Apple has seen its market capitalisation double in a year, adding another $500bn to its valuation, and is worth as much as the entire Australian equity market (1).
While their historic success has undoubtedly been an important driver in this growth, their share price growth has become self-reinforcing. These companies have grown to become a larger and more dominant share of the major US and global indices. US index funds have been the beneficiaries of much of the liquidity created by the Federal Reserve this year, with assets under management smashing through the $10 trillion level.
The S&P 500 index has around 10% of its overall market capitalisation in Apple and Microsoft, with technology as a whole making up over 23% (2). In the Nasdaq Composite, these five FAAMG companies form around one-third of the index (3). Even in global indices such as the MSCI World, these technology companies dominate, with around 10% of the overall market capitalisation. The FAAMG’s importance in stock markets is higher once other technology firms and associated service providers to these companies are taken into account.
Is this necessarily a problem? After all, technology is integrated in all of our lives - perhaps these companies merit their high valuations? However, the recent rise in share prices has not been matched by an expansion in earnings, rather – our research suggests – it is driven by loosening monetary policy.
The Federal Reserve comprehensively reversed its normalisation plan in 2019. There has been a sharp increase in the Fed’s balance sheet and it is now back to levels last seen 18 months ago. Each extra burst of liquidity, whether this involves an expansion in the Fed’s balance sheet or signalling lower interest rates, has found its way into stock markets, giving natural impetus to the largest stocks within the index.
Nevertheless, Fed Chair Jerome Powell has signalled that rates are on hold from here. In its most recent meeting, the monetary policy committee said the current stance was ‘appropriate’ and removed all reference to ‘uncertainties’ in its outlook (4). Markets took this as a sign that the current round of rate cuts is at an end.
This is likely to halt the momentum of the highly-valued technology sector. We believe US recession risk has been mitigated by the trade agreement with China, plus a recovery in the manufacturing sector, strong consumer confidence and healthy non-farm payrolls. However, the technology sector now trades on 7.7 times its book value (the value of assets on a companies’ balance sheets), the highest level since the tech boom in 2000. It also faces a risk of being broken up and/or seeing greater regulation should a progressive left Democratic candidate win the presidency in November 2020.
It has become commonplace to say: ‘don’t fight the Fed’. Technology companies have been supported by loosening monetary policy. However, without that tailwind, investors may look more closely at valuations in 2020. We believe there are better opportunities elsewhere in the year ahead.
- Datastream / Smith & Williamson Investment Management at 22nd January 2020
Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of publication.
Smith & Williamson Investment Management LLP is part of the Smith & Williamson group.
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