by Olivier d'Assier
There is no denying the success that the Tech sector has enjoyed in the last 20 years, both in terms of profitability and valuation, but has the latter gone too far? Bears are quick to point out similarities between the valuation reached for certain non-profitable IPOs and the euphoria of the Tech Bubble in 1999. Using the Russell 1000 as our sample US Equities portfolio, we set out to compare today’s (October 19 2018) exposures to the AX-US4 Tech sector industry factors with their 1999 counterpart. What we found was as revealing as it was un-surprising.
Broadly speaking the Tech Sector can be divided into two categories. The first deals with ‘Hardware and Infrastructure’ on which the sector runs. This includes industries like Communications Equipment, Telecommunication, Hardware & Storage Peripherals, and Semiconductor Equipment. Let’s call these “Group A”. The second category deals with the ‘Software and Services’ which run on this infrastructure and which consumers use and pay for. These include industries like IT Services, Internet and Software Services, and Internet & Direct Marketing Retail. Let’s call these “Group B”.
The chart below shows the aggregate weight and % of Risk in the Russell 1000, on December 31st 1999 and October 19 2018 (detailed tables can be found at the end of the post). In aggregate, the Tech Sector was 37% of the index then, it is 31% of the index today. It contributed 39% of the risk then, compared to 35% today.
Two conclusions come out of this chart. First, there has been a clear switch in investors’ preference from companies that enabled the tech sector by manufacturing hardware and communication equipment back in 1999 (Group A), to those companies that leveraged this infrastructure to build software services and online shopping (Group B). In other words, now that everyone has a computer, both at home and in their pocket, the focus has switched from purchasing one to how much we are using it to ‘buy stuff we don’t need, with money we don’t have, from people we never want to meet’.
The second conclusion is that as of last week, just like in 1999, the industries that make-up the Tech Sector are all contributing more to benchmark risk than their weight in the index would suggest[1].
But are Tech industries really riskier today than they were in 1999 at the height of the tech bubble exuberance? The chart below compares the average volatility forecasted by the AXUS4-MH model for both Group A & B on both dates. On average, Group A’s volatility today is only 53% of what it was in 1999. Group B’s average volatility is 59% of what it was back then.
Wrapping things up by putting them into context, the volatility of the Russell 1000 Index using the AXUS4-MH model in December 1999 was 20.1%; it was only 11.3% as of October 19 2018. So, while the Tech sector does not seem to be responsible for the recent bout of volatility, maybe investors are. Both the sector’s average volatility and contribution to total index risk are lower today, but most portfolios will be dominated by a few big names (i.e. FANGS) thereby creating increased concentration risk. So, while we may be quick to point the finger at this sector given the fact that the bursting of the tech bubble in 2000 has not yet left collective consciousness, we may simply have forgotten how to build well diversified portfolios and are paying the price for it.
[1] There is only one exception, Diversified Telecommunication Services (see table at the end for details)
