Friday, August 7th, 2020

Party Like It’s 1999

This is not an original thought, but there is an odd symmetry between the circumstances surrounding this Tech boom and the previous one in 1999/2000. They were the both facilitated by a period of exceptional monetary stimulus in response to a bug – the Millennium Bug in 1999 and Covid-19 today. For those who don’t remember, the Millennium Bug was a theory that the operating systems of old computers would not be able to cope with the change of the century because their calendars were only set up with two digits for a year rather than four. It sounds ridiculous now, but the Fed was sufficiently nervous that it ran a very accommodative monetary policy into the turn of the century, despite that fact that GDP growth was over 4%.

At the time, there was the same rather fruitless debate about high valuations and paradigm shifts that we have now. We say “fruitless”, because it’s impossible to give a number ex-ante for the PE ratio or any other metric, which all investors would agree was too expensive. There are too many variables and too many unknowns. What we can do is observe the balance of risk and return and see whether the extra risk of investing in Tech is justified by the extra returns it generates. This allows to do two things: (1) identify a recommended weight relative to benchmark which precisely balances the probabilities of higher or lower returns; (2) track how this number changes from week to week.

The good news is that our model recommends a weighting in the US Tech sector which is 87% above benchmark. The bad news is that this figure peaked at 99% in early February and was above 90% for almost all of the period between December and mid-July. It is not impossible for Tech regain these levels, but the risk that it won’t is increasing. Last week, the recommended weighting for Tech sector broke down through its 52-week moving average, which itself is the highest it has ever been in the 25-year history of this model. There is no magic in this relationship, but by definition it doesn’t happen very often and it is worth paying attention to previous outcomes.

There have only been seven occasions, where the recommended weight has fallen below its 52-week MAV, while the sector was rated overweight and the MAV was peaking, (which it is now). Six out of seven times, the recommended weight did not bottom until it reached underweight territory. The exception is the most recent episode, in May 2018, where the sector just avoided a downgrade to underweight in January 2019. We see no reason to disregard these results. The best-case scenario is that Tech performs in line with the index for the rest of the year. The worst is that there is a period of extended underperformance, possibly prompted by a return to more normal monetary conditions as the Covid-19 pandemic recedes.

The Covid-economy theme is not just confined to Tech. The Communications sector (Facebook and Google) is currently rated at 38% overweight, just below its recent peak in May 2020. If the current retracement continues, it will break down through its 52-week MAV by the end of August – if not sooner. If these two sectors generate the same signal within a month of each other, the impact is likely to be cumulative. Tech would underperform because Communications was underperforming and vice versa. It wouldn’t be the end of the world – certainly not in comparison with the pandemic – but it would cause a lot of pain to a lot of portfolios.

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