Have you ever heard of “irrational exuberance”? Alan Greenspan coined the term in his famous 1996 speech “The Challenge of Central Banking in a Democratic Society.” In his address, Greenspan explained that low inflation: reduces investor uncertainty, lowers risk premiums, and implies higher stock-market returns. He gave this speech at the beginning of the 1990s dot-com bubble, which turned out to be a textbook example of irrational exuberance.
Once again, in 2017, U.S. large caps were up more than 20%, the ninth year in a row US large caps were in positive territory. The last time this happened was during the 1990s. Like U.S. markets back then, last year was dominated by technology stocks, which were up nearly 40% as a group, mainly because of five stocks: Apple, Microsoft, Amazon, Alphabet and Facebook.
Should this concern you? Is this a repeat of the 1990s? Back then, technology stocks dominated the market. Technology valuations skyrocketed and drove the overall market to bubble territory, which eventually went down in flames around March 2000. The NASDAQ, a tech-heavy stock index, reached 5,000 and then dropped to about 1,000 in 2002; it didn’t reach the 5,000-level again for 13 years. This is what haunts every stock investor. Bubbles never end well as we also experienced in 2008 with the real estate market.
Then vs. Now
What’s different today? Are we in bubble territory again? Probably not. Prices relative to earnings remain subdued this time around; back in the 90s, technology companies had little or even negative earnings. Now technology stocks are actually making lots of money. And the ones that aren’t, never go public, opting instead to stay private by raising money via venture capital funds.
Having said that, prices do appear to have gotten ahead of earnings and valuations seem stretched. Technology stocks represented 19% of the U.S. large-cap index just three years ago, and have now risen close to a 25% weighting. On a weighted-average basis, the technology group trades at valuations nearly twice the S&P 500’s largest U.S. companies.
What should the prudent investor do? Avoid following the herd and diversify away from these companies. Most technology stocks dominating the market speculation are categorized as U.S. large-cap companies. The first step is to invest in mid- and small-cap companies where tech stocks are underweighted 8% relative to the overall market. Tilting toward value investments (stocks trading well below their book value) also helps the cause.
More importantly, keep in mind that I’m referring to U.S. large-caps stocks, which only make up one-fifth of an aggressive stock portfolio. In our global value-focused equity strategy, 40-50% of stock investments are in companies domiciled outside the U.S. They also tend to be smaller, cheaper companies. This is significant because technology stocks represent nearly 24% of the U.S. large-cap index, yet they only make up 12-15% of stocks in the portfolios we’ve built. The top-five tech stocks mentioned above account for more than 13% of the U.S. large-cap stock index, but represent less than 4% of our portfolio. That’s barely a blip on the radar screen, especially considering our portfolios invest in bonds and alternatives, which further reduce exposure to this sector.
An Additional Lift
There are some tailwinds here too. First, investors back in the 90s were investing in the potential of the internet. Today, smartphones, cloud computing, online shopping, and social media have transformed companies and industries. Additionally, interest rates are still low and corporate taxes are dropping.
In business school, you learn outsized profits don’t last long because competitors move in, but this does not seem to be happening yet. Just look at Apple, who was able to raise its prices to a $1,000 per phone without consumers flinching. Meanwhile, Toys”R”Us is the latest casualty of Amazon’s massive disruption of the retail industry with grocery and pharmaceutical sectors next on the list.
Regardless, one prudent investor guideline espoused by CFA Institute, the money-management governing body, is that fiduciaries must invest assets as if they were their own. I diversify everything in my life so that’s why I often stress this to you.
And yes, we absolutely treat your money like our own. I suspect many of you won’t be surprised to learn our money is invested in the same portfolio as yours. It’s a more “rational” approach to managing money. At Redwood, we wouldn’t have it any other way. Enjoy 2018!
LANE STEINBERGER, CFA, CFP®
PARTNER, CHIEF INVESTMENT OFFICER