During late spring and the summer some voices has been raising concern that the financial markets are not accurately reflecting the economy. While it has been clear that the global economy has taken a beating by the coronavirus, Swedish GDP plunged by 8.6 percent in Q2, the financial markets has been recovering well into the late summer. Currently the S&P 500 is up about 8% year to date, as of August 26.
I am not going to speculate about whether the markets are too optimistic about the future, but I am going to talk about concentration in the S&P 500 and the performance of big tech during the pandemic.
As of August 26, when I got the data, the five largest firms in the index made up roughly a quarter of the entire index. These firms are Apple, Microsoft, Amazon, Alphabet, and Facebook. In the table below and the graph above I have collected some data on the performance of these tech stocks and the S&P500. The table shows the weights of the firms and the collective performance of the firms in the index. As we can see, the five largest stocks have contributed 12.81% of the total return of the S&P index which is more than the total return of the index year to date. The rest of the 495 firms have therefore collectively returned -4.79% year to date. Investors may not be as positive about the future as some people speculate, instead it may be that tech firms are more fit to take advantage of the current environment than most other firms.
Let us inquire about these potential advantages.
The first advantage that tech firms with high growth rates have toward other firms in the economy is the low rate environment. The FED funds rate has basically hit the lower bound, it currently is situated between 0 and 25 bps, and it is probably going to stay there for a few years ahead. From a pure technical valuation standpoint, low rates are beneficial for high growth firms as it lowers the discount factor used in discounting cash flows etc. Thus, low rates warrant higher valuations all things equal. And this especially favors firms with high growth rates, as they have huge cash flows far into the future. With rates at almost zero, the cash flows far into the future becomes more valuable and valuations skyrocket.
The second advantage may come from the pandemic itself. Productivity rates have been declining for a long time in the West, a problem that probably has many complex bases. The tech boom has not been very successful in increasing the productivity rates thus far. One reason for the absent increase may be that our society has not been fit to exploit the benefits that tech may give us. The pandemic has somewhat increased the rate of tech adoption, and some pundits have been saying that the pandemic moved us 10s of years into the future of tech, which may be a step towards a better society-wide exploitation of tech. If this happens, then this may warrant higher valuations of the large tech firms, as they are the ones that are going to provide the tools necessary to increase productivity.
The products and services that the tech firms have also proven to be independent from the need for a functioning physical economy, they can still be provided through fast shipping and online means. If the rest of the economy is going to make the transition into a more digital and non-physical economy, the tech firms are needed in that transition. Which also may be a reason for high valuations.
To summarize, we have identified three reasons that the valuations of big tech are racing away from the rest of the economy. (1) The low rate environment favors firms with large cash flows in the distant future, from a purely technical perspective at least, (2) big tech-firms are the main producers of the tools that may increase societal productivity and the pandemic has made society better prepared to exploit the productivity advantages of tech. (3) Finally, the products and services of these firms are not dependent on a functioning physical economy.
Some risks arise from these huge firms. I will consider these risks in my next post.