“At the root of all financial bubbles is a good idea carried to excess”
- Seth Klarman, founder of Baupost Group
The classic playbook in a decelerating economic environment is to overweight technology stocks. As earnings growth becomes harder to achieve for the broader market and discount rates tend to fall, multiples rise the most for those companies that can deliver earnings progression. A few problems have emerged with this approach. Delayed monetary policy tightening may have an amplified effect on expensive technology stocks. Absent that, valuations themselves suggest relatively poor absolute and relative returns. Tech is also not all that defensive with high market beta and high ‘downside capture’, so in a period of lower forward returns on most assets it is not really accretive to portfolios. US tech should be considered an underweight relative to healthcare.
Firstly, new research from the IMF suggests that it is predominantly monetary policymakers’ reaction to inflation that explains the equity markets’ usual negative response to it. As the Federal Reserve has changed its reaction function, this negative effect of inflation may have been delayed versus previous cycles. The relative performance of the technology sector is strongly linked to these falling discount rates (chart below).
In contrast, many East Asian countries continue with much more orthodox policies (see: China) or have already commenced tightening (see: China, Korea, Taiwan, or Singapore). Asian equities are more likely to have felt the brunt of this already, while the Fed has some catching up to do.
This Wednesday’s FOMC meeting may have heightened importance. Bill Dudley, a former vice-chair of FOMC, puts the required adjustment into context and argues the Fed should go above the “neutral” rate of 2.5%, which is the level of interest rates during a steady state is neither expansionary nor contractionary to economic activity. “The shift in the Fed’s interest-rate projections might come as a shock to markets. Futures prices suggest that investors are expecting two or three 0.25-percentage-point rate hikes in 2022. But the total magnitude of tightening has not increased: Eurodollar futures imply a peak in the federal funds rate of around 1.5%. That’s well below the levels projected by every member of the Federal Open Market Committee, and well below what common sense would dictate.”
Valuations for the technology sector suggest very low forward returns in an absolute sense. In contrast, forward returns in healthcare look much more defensible.
Market cap weights. Index composition in appendix.
Source: AQR. Portfolios are an updated and extended version used in Frazzini, Andrea and Lasse H. Pedersen (2014), “Betting Against Beta," Journal of Financial Economics, 111, 1–25. Shown on log scale.
Moreover, the prospect of accelerated monetary tightening and persistent inflation overshoots may favor a low-beta strategy, which itself is a consistent driver of alpha over time (below). Here healthcare (0.85x) ranks much better than technology (~1.1x) for similar levels of historical earnings growth (9.8% vs 10.7% from 1995 to 2021). Analyzing the historical performance attributes of the key sectors captures the fact that the technology tends to underperform during periods of weak market returns.
Source: Kenneth French; returns since 1969 using sub-sector returns.
Appendix:
Technology Index includes: Apple, Microsoft, Adobe, Intel, Cisco, Applied Materials, Oracle, Texas Instruments, Cadence Design, Autodesk, Fiserv, & Advanced Micro Devices.
Healthcare Index includes: JNJ, Pfizer, Lilly, Merck, Bristol Myers, Viatris, Thermo-Fisher, Medtronic, Abbott Labs, Stryker, CVS Health, UnitedHealth.