A change in fortunes for the technology stocks saw falls for US equity markets, which have been led by an increasingly narrow band of mega-cap names from the sector.
And while the sector has played an important role in the market rally this year, investors are again starting to debate whether tech stocks are in bubble territory.
Apple and Tesla’s recent stock splits, (which added $653bn and $187bn in market value respectively) echoes the kind of environment that Federal Reserve chair Alan Greenspan cited as “irrational exuberance” in 1996, which served as a precursor for the dotcom bust.
As such, David Jane, manager in the Premier Miton Investors’ macro-thematic multi-asset team, looks at the components of a stock bubble and considers whether one is growing in markets now.
He said: “There has recently been a fair amount of talk about the huge price moves we have been seeing in a small number of large US companies in the ‘new economy’ space.
“This is particularly stark when contrasted with the weakness in many ‘old economy’ areas, one recent consequence is that Apple is now worth more than the FTSE 100 index.”
Jane continued: “Bubbles in markets generally come about for similar reasons. Firstly, you need an unarguable truth, in this case that the growth of the digital economy has been brought forward many years by recent events.”
Other market bubbles have come about feeding off similar stories, such as the rise of China or the emergence of the internet, the fund manager explained.
“There always needs to be a compelling argument such that anyone arguing against buying into it appears to be denying an absolute truth,” Jane added.
Secondly, you need an ample level of liquidity for the bubble to inflate and sustain, he said, something that has been provided by central banks in the form of quantitative easing for a number of years.
“Past bubbles have generally burst when a central bank has withdrawn support too aggressively or unexpectedly,” he said. “Without new money to chase up valuations, bubbles cannot continue.”
Other factors, that are not as crucial to the development of bubbles but nonetheless do occur is the emergence of a new class of investor entering the market.
He highlighted the influx of retail investors with excess savings during the 2014/5 China bubble and the disenfranchised millennial investor which characterised the 2016/17 Bitcoin bubble.
“People point to Robinhood investors taking advantage of fractional shares and bored sport betting enthusiasts unable to gamble on cancelled events,” he said.
Robinhood reported in May that three million accounts had been created during 2020, which may have seen more speculative traders entering the market and inflating stock prices.
Jane added: “There are always stories such as these, often used to explain why more seasoned investors are missing out while the naïve are piling in.”
Another common feature of a bubble is an asset that is difficult to value, he said, “creating opportunity for quite extreme outcomes”.
He asked: “What is a Bitcoin worth in valuation terms, or a Tesla, with some probability of having a future monopoly in an industry.
“These are purely opinion valuations rather than traditional cash flow or dividend models.”
The Premier Miton manager also highlighted ‘price action’ as one of the defining features of a bubble, which is characterised by accelerating gains over the course of the bubble and ‘each day’s gain typically greater than the previous’.
One of the most important features of a bubble is that they eventually burst, Jane added, as no new investors can be persuaded to join in.
“It is this price action that determines whether a market is in a true bubble or whether it is merely going up, fairly or otherwise.
Nevertheless, calling the top of the bubble equally challenging, “as they are by their very nature not rational or based on fundamentals”.
“One back of the envelope method to call the top, however, is to consider the highest valuation anyone might be prepared to pay for an asset, based on the most positive assumptions you might make,” he said.
“Such signals only work with hindsight, however, as do other anecdotal methods such as value investors capitulating or the FTSE 100 index being worth less than Apple.”
On Apple, Jane said its position, high profitability and strong balance sheet mean that it’s unlikely to be in bubble territory.
Performance of Apple YTD (in US dollar)
Source: FE Analytics
However, he conceded that Tesla, “has appeared to have gone parabolic with a valuation now greatly exceed that of any of its rivals”.
“At present, in general, valuations are within sight of fundamentals and stocks are generally rising rather than accelerating,” he said. “So, our conclusion is we are not obviously in a bubble in these technology stocks, with a few notable exceptions.”
He concluded: “This doesn’t necessarily mean they are not overvalued but our approach is to continue to run trends once they are in place, but being alert to the risks, should they change.
“The most obvious one being the withdrawal of liquidity, if central banks tighten all bets are off.”