Will a Technology bust be a repeat of the Dotcom Bubble?

Information Technology Sector since 1990
Source: FactSet

Over the past thirty years, we have seen the overall stock market in the U.S. collapse twice. Prior to each of these events, we noted a marked outperformance of Information Technology (IT) to the rest of the market. In the decade leading up to the dotcom bust, the IT sector had outperformed the markets by approximately 200%. In the next two years, the sector gave back all its outperformance of the prior ten years.

Most chart watchers would assume that in the next major downturn, the IT sector will once again revert to the mean and converge to the S&P 500 line. However, one should look at certain metrics to verify such suspicion. Looking at the fundamental differences between the two indices, it is not at all clear that this time the IT sector will crash back to the same levels as the broader index.

There are currently 71 stocks in the IT sector making up 28% of the market capitalization of the S&P 500 Index. In examining the average valuations of the technology sector, it is, as would be expected, more expensive than the overall index indicating that there is the risk of the valuation metrics converging. Currently, the IT sector is trading at a price multiple of 25.1 times its earnings. This indicates that the market is valuing every dollar of earnings from a technology company above the same dollar for the S&P 500 where the price multiple is 21.9 times its earnings. The same is true when comparing a price to book value ratio, where the market value of the IT sector is 8 times its book value, versus 3.4 times for the index. Price to sales is valued at 5.3 times for the sector, versus 2.2 times for the S&P 500 Index. All of these ratios indicate that if one were to value each dollar of earnings, book value and sales, the same for the IT sector as the S&P 500 Index, technology stocks would have to fall in value, relative to the rest of the market.

 
Information Technology Sector Valuations
Source: FactSet

However, there are good reasons that the market is applying these inequitable measures to the above metrics. The sector is operating more efficiently than the rest of the market. For example, the return on equity that the IT sector is achieving for its shareholders is 32.1%, versus roughly half of that for the shareholders in the companies that make up the whole S&P 500. The IT sector is also far less leveraged than the rest of the market and this is positive as it gives these companies a lower risk profile.

The dividend profile is more positive for investors of the broad index, but this indicates that the IT sector is retaining more of its earnings and their dividend is less vulnerable to cuts in the event of an economic downturn than the rest of the market. These companies often claim to be using the earnings to invest for further growth.

The geographic mix of earnings is a debatable subject from a risk point-of-view. Is it better to have one’s earnings more widely diversified around the world or is it better to have more earnings at home in the U.S. where “they are safe” and not subject to the whims or tax grabs of foreign governments? We have taken the attitude that generally, diversification is a good thing, however, the two geographic areas with the most risk are China due to a potential trade war with the U.S., and the U.S. due to its poor handling of the COVID-19 crisis which will likely hurt its economy and postpone a recovery longer than Europe or the rest of Asia Pacific.

Overall, we would not expect the IT sector to give back all its outperformance from the last decade as it did during the dotcom crash, as the companies making up the sector now are better balanced and make better profits than their counterparts of twenty years ago.

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