The S&P 500 index has officially completed a V-shaped recovery in August, storming back from the depth of the crisis in March.  Moreover, it also managed to set a new record high during the month, six months after its previous high registered on February 19, 2020.  In effect, this will go down as the fastest recovery in history, with the index first falling by over 39 per cent to its bear-market low on March 23 and then recovering by more than 50 per cent through August. 

Even more pronounced was the bounce in the Nasdaq 100 index which completed the recovery over a period of 75 days from its lowest point in March, rallying by 30 per cent so far this year and headed for one of its best years of the last two decades. 

 The main triggers for this impressive reversal of trend may be attributed to the unprecedented fiscal and monetary stimulus that was put in place, signs of macro re-acceleration as economies across the globe started to reopen and better-than-feared earnings as companies and consumers adjusted to business and life in a coronavirus world. 

A full rebound is still far off – for economic activity, employment or corporate earnings – but investors are betting it will come and stocks move ahead of reality.  While elevated valuations are a concern, it typically is not considered the main trigger leading to a change of trend.

However, it is worthwhile to point out that, when adjusted on an equal weighted basis, the average stock in the S&P 500 index is still down by about four per cent for the year, even though the average itself is up by around 3.5 per cent so far this year.  This is because the S&P 500 index (similar to the majority of indexes globally) is a market cap-weighted index, meaning that the bigger the market capitalisation of the stock, the bigger the impact. 

Apple is a good example, as it is the largest company by market cap in the index, having recently surged past the $2 trillion mark in terms of market value.  In effect, the company represents around 6.7 per cent of the total market value of the S&P 500.  Taken as a group, the top five companies in the S&P 500 index (namely Apple, Microsoft, Amazon, Facebook and Alphabet) together account for around 21.3 per cent of the total market value of the index. 

In a recent study by Bespoke Investment Group, the research house demonstrated that through mid-July, the seven largest companies in the S&P 500 were up 45 per cent year-to-date, while the rest of the S&P 500 had declined by 11 per cent. 

This goes to show that the top seven stocks move the index around so much that the bottom 493 stocks get lost in the shuffle.  Much more than survive the pandemic lockdown, the largest American tech companies are seeing their advantage widen drastically as a result of it, with investors flocking to anything with size and stability. 

We had a similar skew of technology stocks pulling the S&P 500 index up in early 2000.  Indeed, the Nasdaq 100 is today trading at a very lofty valuation.  Data provided by Bloomberg shows that, as of the time of writing, the Nasdaq 100 Index was trading at a P/E multiple of 36.4.  At its current level, the Nasdaq 100 index is trading at 3.3 times the value of the S&P 500. 

Big tech companies are here to stay and expect them to be leaders

According to The Wall Street Journal, the last time the index traded at this valuation versus the S&P 500 was on March 10, 2000 – the exact date of the peak of the Nasdaq Composite at 5,048.  It did not reach those levels for over 15 years – and the S&P 500 peaked two weeks later. 

However, the big difference since then is that the volume of sales, earnings and margins were only a fraction of what they are today. In the year just before the internet crash, companies in the S&P 500 Information Technology Index earned combined profits of roughly US$50 billion.

Last year, the total was $240 billion.  So, while the Nasdaq 100 has come back to its heyday relative to the broader market, the underlying earnings power is almost five times as much as it was 20 years ago.

In reality, very few saw this coming.  Back before the coronavirus rattled the globe, many market participants would argue that when the bull market comes to an end, its first casualties would have been the high-valuation technology stocks. 

Reality didn’t play out that way.  Rather, the sector’s balance sheets and automated, stay-at-home characteristics acted as insulation from the worst of this year’s declines.  The conventional wisdom is that tech will stay strong as it holds the future to our working and personal lives, driven by secular trends like 5G, the Internet of Things, cloud computing, cybersecurity, artificial intelligence, augmented reality, autonomous driving, e-commerce fintech and more. Some actually argue that this virus has brought forward those companies’ businesses by between two and three years. 

The other big difference is the unprecedented support for the financial markets coming from the Federal Reserve and the US Treasury.  This had the effect of flattening the yield curve, so much so that today, the S&P 500 yields around four times as much over the 10-year Treasury. 

This means that, if one considers getting out of the market, he/she may regret it at this stage and would want to get back in because the yield in the stock market is higher than wherever you want to go.  In this case, this money is going into the tech sector and, more notably, in the Nasdaq 100 index which is highly skewed towards the sector.

This has now become the most crowded trade in history, so much so that many market participants have started to refer to this small selection of mega stocks as effective ‘safe havens’ with defensive business models and guaranteed double-digit earnings growth. This does not, however, provide insurance against those sudden bouts of volatility that characerise the stock market from time to time. 

One such prospective catalyst being cited by market participants is the discovery of a vaccine for the COVID-19 coronavirus.  While on the one hand a vaccine should provide a significant boost to the world economy, it could also spur investors to unwind part of their positioning in the current market leaders that have helped propel the market higher. Value stocks which are defined as shares trading at low prices relative to their earnings or assets might emerge as the new winners in a post-vaccine world. 

That’s particularly the case for such laggards as airlines, cruise ships, casinos, materials, companies selling non-essential items and financial companies. This has the potential to be one of the great trades of the past decade as these stocks have been crushed for a second time this summer, with the majority sitting back down at or just above their March lows.

Under this assumption, the overcrowded tech sector could become a huge source of funds for buying the ‘reopening stocks’, which will see massive inflows as the notion of life as we knew it pre-COVID takes a firm grip on sentiment.

These stocks are trading between 50 and 75 per cent off their 52-week highs and present a similar buying opportunity when the timeline of a global vaccine becomes clear. 

Investors should prepare themselves for this scenario which may or may not be realised.  However, we believe that, ultimately, the big tech companies are here to stay and expect them to continue to be leaders in the market over the long term because as the COVID event has demonstrated, their strong fundamentals, resilience and flexibility cannot easily be sought in other pockets of the market.

This article was issued by Stephen Borg, head of Wealth and Fund Management at Calamatta Cuschieri. For more information, visit www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.

Stephen Borg, head of Wealth and Fund Management at Calamatta Cuschieri