When the Most Expensive Also Becomes the Safe Haven

The drop in interest rates so far this year has led to strong performance from the two most interest rate-sensitive sectors in the S&P 500: Utilities and Real Estate. In fact, those two sectors are among the best-performing this year with gains of 8.2% and 6.4% (not including dividends), respectively, through yesterday’s close. The strength makes perfect sense because many investors view Utilities and Real Estate stocks as substitutes for bonds and other fixed-income securities. In other words, when the interest rates available from bonds or CDs fall, more investors seek to enhance their investment income through the relatively large dividends offered by Utilities and Real Estate stocks.

But neither the Utilities sector nor the Real Estate sector is the top performer so far this year. That distinction goes to, you guessed it, the Technology sector. The S&P 500 Technology sector is up 11.8% so far this year after posting a huge 48% gain in 2019. Tech stocks were also the best-performing sector in 2017, and from the end of 2016 through yesterday, the technology sector was up over 123% – very nearly double the next-best performing sector (Consumer Discretionary, at + 62%). Tech’s latest feat came earlier this week when the sector roundly shrugged off a profit warning from Apple. Though the warning was solely related to the effects of the coronavirus, it was still a good example of the incredible resilience that the sector has displayed in recent years.
You may be asking yourself, how can the sector with the most octane by far also be the most defensive in the face of an onslaught of bad news. The chart below shows how three key industry sectors performed in the face of the negative news flow surrounding the coronavirus. As we would expect, the economically sensitive Energy and Materials sectors have struggled the most as fears have mounted about the virus’s impact on global economic growth. However, you will also see that the technology sector (blue line) has repeatedly shrugged off all the bad news and has posted a very nice gain for the year. Is this to be expected or are investors falling too far in love with yesterday’s darlings?
There are a couple good reasons why technology might outperform in an environment such as this. First, if the global economy is truly slowing as a result of the coronavirus, then scarce earnings growth will command a premium. Technology companies, especially the mega-cap names we hear so much about, have proven their ability to grow earnings even against the backdrop of slow economic growth. Second, because many technology companies are growing rapidly and need capital to support their growth, they tend to pay lower (if any) dividends. As a result, investors in technology stocks generally expect to get the lion’s share of their returns several years in the future. If we now need to use a lower discount rate (as a result of the drop in interest rates) to value those future cash flows, then it makes sense that technology stocks would rise as interest rates are falling. And one final reason that many cling to tech is that people just don’t like to sell their winners. It’s this last reason that makes me a little worried.
We at Farr, Miller & Washington have four reasons for selling stocks, and one of them is valuation. There is a difference between a great company and a great stock, and we try very hard not to confuse the two. Amazon is an incredible company, and very well could wind up being a great stock (even from these lofty levels). But there are a lot of things that need to go right, in our view, to justify a nearly $1.1 trillion valuation (which translates to about 75x the consensus estimate for 2020 EPS). One of the big questions with Amazon is to what extent is it abusing its market power, which has grown enormously over the past several years. Can anyone be sure that the competitive ferocity and market power that has generated so much negative press for Amazon won’t also attract political and/or regulatory action? And what will be the investment implications if so?
Warren Buffett said, “Be fearful when others are greedy and greedy when others are fearful.” Without question, there could still be a good long runway before this bull market is over. And Technology stocks (including the mega-caps) could continue to lead the way. But does it make sense at this point to pile into the very stocks that have driven the indices to these record levels? Valuations will matter again, and when they do we think investors will be thankful they heeded the warning signs.