In January, stock markets in developed countries continued the upward trend that began last October. The S&P 500 index, which reflects the value of the top 500 companies in the US, rose by 1.6%, paralleled by a 2.9% ascent in the Euro Stoxx 50 index, which tracks major European companies. Conversely, emerging market stock exchanges experienced a downturn, with the MSCI Emerging Markets stock index dropping by 4.7%. This was largely due to a more than 10% decline in Chinese stock markets.
The movement of stock indices mirrors market optimism regarding the containment of inflationary pressures and the anticipated six interest rate cuts by the US Federal Reserve throughout 2024. However, the Federal Reserve warns against excessive optimism, urging investors to exercise caution, as it predicts that this process may not unfold as smoothly or quickly as hoped.
While stock and bond indices moved in tandem during the final quarter of 2023, bond investors diverged from the optimism exhibited by stock investors in January 2024. Interest rates on long-term bonds rose slightly, leading to lower bond prices, while stock indices appreciated.
Stock markets, particularly the share prices of the six US technology titans – Apple, Amazon, Microsoft, Alphabet, Meta and Nvidia – reflect the belief that inflation has been surmounted without compromising economic growth. Despite these being the world’s most valuable companies, investors appear confident in their ability to further expand market share and bolster sales volume and revenue. Therefore, investors are willing to pay 25 to 45 times the annual earnings for these stocks.
Edward Harrison published an interesting opinion piece on Bloomberg about the triumph of the tech sector’s stocks after the financial crisis, where he discusses the success and failures of various economic sectors through multiple market cycles.
The share of the US tech sector in the S&P 500 is again approaching one-third of the index’s value.
Figure 1. Share of the market value of US IT sector stocks in the S&P 500. Source: Société Générale.
In 2023, profits of tech sector companies followed an upward trajectory, contrasting with a marginal decline in the average profits of other firms comprising the S&P 500. When winners seize the lion’s share of gains, little is left for the rest.
Figure 2. 12-month expected earnings per share for S&P 500 companies. including the tech sector (red) and excluding the tech sector (black). Source: Société Générale.
However, the growth in the value of tech sector companies last year was not so much due to profit growth but rather the growth in price-to-earnings (P/E) ratios.
Figure 3. The price level index of US tech companies’ stocks (red) and the trailing 12-month earnings per share (black) of these companies. Source: Société Générale.
It is part of the zeitgeist that the main factor affecting the value of large public (listed) companies is no longer their profit but rather investor sentiment and appetite for risk, which in turn largely depend on central banks’ monetary policy. Stock prices began their ascent towards the end of October 2023, as markets sensed that the cycle of interest rate hikes had likely concluded, with anticipation mounting for an imminent reduction in interest rates.
As seen from the above chart, the P/E ratios of US tech companies have significantly increased. For example, as of the end of January, Nvidia, a technology giant producing microchips and graphics cards for AI-specific supercomputers, had a P/E ratio of 83, with a price-to-sales (P/S) ratio of 30 (down from 45 in July 2023).
This price level inevitably brings to mind a comment from Scott McNealy, the former CEO of Sun Microsystems and one of the brightest stars of the previous tech boom, regarding his company’s stock price: “At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”
In short, McNealy suggested that investors should pay more attention to companies’ financial performance and consider which assumptions are realistic and which are not.
In March 2000, Sun Microsystems was worth $150 billion, with annual sales of $15 billion. Thus, its P/S ratio was 10. Two years later, after the tech bubble burst, the stock had lost 90% of its market value. As of the end of January, Nvidia’s stock was essentially three times more expensive (compared to its financial performance) than Sun Microsystems’ stock at its peak!
By the way, the present occupant of Sun’s former headquarters, Meta Platforms (formerly Facebook), opted not to replace the sign at the building’s entrance but simply flipped it around. San Francisco and Silicon Valley are a breeding ground for burgeoning tech companies. However, they are also a graveyard for old tech companies and ideas that were ahead of their time, providing a fertile ground for new ones.
As my readers are aware, I have harboured concerns about the trajectory of the global economy and the escalating debt burdens for some time now. The only saving grace could be a positive technology shock that boosts productivity and helps reduce both relative and, ideally, real debt burdens through economic expansion. Perhaps the current level of tech sector stock prices reflects this last hope pinned on one card.
However, as an investor, I am not convinced that relying solely on hope and betting on one card is the right strategy. If productivity does not improve rapidly, the debt burden does not decrease, and the pace of consumer price growth and interest rates remains high for longer than currently assumed, then investors’ optimistic sentiment may quickly shift to the other extreme. For example, the well-known US investment firm GMO forecasts that the average inflation-adjusted annual return on US stocks will be negative over the next seven years.
Figure 4. Expected annual real return of various asset classes over the next seven years. Source: GMO.
Although prepared for market declines, LHV pension funds have long ceased to bet on them. Instead, we focus on finding strong companies and projects that offer decent cash flow with relatively low leverage and reasonable prices.
In January, stock markets in developed countries continued the upward trend that began last October. The S&P 500 index, which reflects the value of the top 500 companies in the US, rose by 1.6%, paralleled by a 2.9% ascent in the Euro Stoxx 50 index, which tracks major European companies. Conversely, emerging market stock exchanges experienced a downturn, with the MSCI Emerging Markets stock index dropping by 4.7%. This was largely due to a more than 10% decline in Chinese stock markets.