At the end of March, we showed that according to Bank of America, we are now witnessing the third biggest bubble in history created by a central bank. As bank CIO Michael Hartnett wrote, "the lowest interest rates in 5,000 years have guaranteed a melt-up trade in risk assets", which Hartnett has called the Icarus Trade since late 2015, and points out that the latest, "e-Commerce" bubble, which consists of AMZN, NFLX, GOOG, TWTR, EBAY, FB, is up 617% since the financial crisis, making it the 3rd largest bubble of the past 40 years, and at this rate - assuming no major drop in the 6 constituent stocks - the e-Commerce bubble is set to become the largest bubble of all time over the next few months."
The problem is that lasting even a few months until a "major drop" in the e-commerce bubble, may prove problematic, largely due to what Hartnett last week dubbed the "Occupy Silicon Valley" movement, which he explains as follows:
The economic & social disruption of technology is unlikely to stop. It has many beneficial economic & social impacts. But the sector’s growth, power & visibility make it extremely vulnerable to increased regulation & taxation, most especially if recession wrecks government finances.
Hartnett then went on list 10 specific reasons why BofA is now advising clients to sell tech stocks (reported below), but the single one, most pressing concern was the threat of regulation, especially in the aftermath of the Facebook Cambridge Analytics fiasco and last week's congressional hearings.
To be sure, it would hardly be the first time that a government, hell bent on extracting its pound of flesh, burst a nascent bubble through regulation: it did the same with tobacco in 1992, finance in 2010, biotech in 2015 and now appears set to do it with e-commerce:
Which brings us to the latest "Weekly Kickstart" report by Goldman's David Kostin, in which the Goldman strategist writes that - just like Citi earlier - "recent weakening in some indicators have prompted clients to question how long the current expansion will last" to which he responds optimistically, pointing out that Goldman economists forecast US GDP of 2.8%, 2.2%, and 1.5% in 2018, 2019, and 2020. Nevertheless - he adds - "a skeptical buy-side community focuses on downside risks."
And of these, none is greater than the Tech Sector.
In the US, Information Technology is the sector most associated with growth. The sector is currently forecast to have among the fastest annual growth in sales and earnings during the next two years. Consensus forecasts sales growth of 15% and 7% for 2018 and 2019 vs. 6% and 5% for the balance of the S&P 500 ex. Energy. Consensus bottom-up EPS growth is also strong: 17% and 9% for Tech vs. 17% and 8% for S&P 500.
And this is where Goldman picks up where Bank of America left off, and notes that "two important forces are disrupting how investors view the Information Technology sector: Regulation and re-classification." These are also the two core reasons investors should consider as they decide whether to sell their info-tech sector holdings. First...
Just as Michael Hartnett has been warning over the past month with his "Occupy Silicon Valley" narrative, so Kostin writes that the risk of future regulation threatens the long-term growth prospects of some Tech companies, and explains:
This week’s Congressional testimony by Facebook (FB) CEO Mark Zuckerberg raised investor concerns about the potential for government regulation of the use of consumer data. Edward Snowden’s actions exposed the vast amounts of data that the US government had been secretly collecting on its citizens. The Zuckerberg hearing revealed to many government officials the scale of personal data that FB users had agreed to allow the firm to gather, raising regulatory risks.
Meanwhile, as Zuckerberg was testfying in DC, Goldman's equity research analysts hosted discussions with policy experts regarding Technology regulations. Their conclusion: while comprehensive data privacy legislation in the US is viewed as unlikely this year, investors should expect regulation through other channels, such as State Attorneys General or self-regulation.
For an indication of what is coming, look no further than Europe, where the General Data Protection Regulation (GDPR) takes effect on May 25.
The GDPR is a new privacy legislation designed to provide more protection and control for EU citizens regarding their personal data, and to govern the collection and use of that data by companies. The scope of GDPR covers all companies who provide services targeted to people within the EU, regardless of where the firms are domiciled. FB has announced that controls and settings implemented in Europe will be made available to users globally.
In assessing the impact of Europe's regulatory push via GDPR, Goldman evaluates the advertising revenue sensitivity to changes in pricing and impression trends, and finds the following:
- FaceBook could potentially see revenue fall by up to 7%, although the impact could be negated if it obtains user consent for processing personal data.
- GOOGL’s net ad sales could witness a -2% to 0% impact from GDPR given the view that Search is largely protected as it relies less on user data to generate advertisements.
Whether such regulation will be repeated in the US is unclear. Still, even a worst case revenue loss scenario does not appear fatal, and at worst may lead to a modest selloff. For context, GS forecasts FB will grow sales by 35% in 2018 (to $55 billion) with a 38% net margin while GOOGL will grow sales by 21% (to $134 billion) with a net margin of 23%. Of course, if the US government really wants to burst the second tech bubble, nothing would be able to stand in its way.
Which brings us to Goldman's second key reason to sell tech stocks, namely...
A few days ago, in response to Congressional questions to Mike Zuckerberg whether Facebook is a tech company, we answered with the following chart from Goldman, which shows how the upcoming S&P industry reclassification will impact companies such as Facebook and Google:
Dear Congress: here is your answer to "Is Facebook a tech company" pic.twitter.com/seB1jurtM6— zerohedge (@zerohedge) April 11, 2018
However, in addition to a useful metric for Congress on how to think about Facebook, the upcoming constituent re-classification in the S&P "represents the second major risk to the Tech sector" according to Goldman.
Some history: "in September, the major index providers MSCI and Standard & Poor’s will re-categorize components of the global equity markets. Using the S&P 500 index as an example, five current constituents (GOOGL, FB, EA, ATVI, TTWO) comprising nearly 20% of the existing Information Technology sector will be re-classified into Communication Services. Following the reclassification, the Information Technology sector weight in the S&P 500 will decline to 20% from 25%."
The implications: "with two of the largest and fastest-growing companies transitioning out of Information Technology, the sector will lose some of its appeal to growth investors. The future “legacy” Tech (i.e., firms remaining in the sector) will have much slower expected sales and earnings growth and lower margins than both the current Tech sector and the new Communication Services sector, which will also include Telecom and select Consumer Discretionary stocks (DIS, NFLX, and others)."
Furthermore, Goldman calculates that the future “legacy Tech” sector has expected 2018 and 2019 sales growth of 9% and 5% and margins of 22% and 23%. However, the “legacy” Tech sector trades at a lower valuation (EV/sales of 3.9x and P/E of 17.5x) compared with existing Tech (4.0x, 18.4x), and the remaining stocks in the S&P 500 (1.8x, 16.4x).
The firms at the top of the Info Tech sector will also change. The largest stocks in the “legacy” Tech sector will be AAPL (19% of sector), MSFT (16%), and INTC (5%), each of which has lower earnings growth but lower valuations, a higher shareholder yield, and less regulatory risk than the departing firms.
What does this mean in a market context? Here's Goldman:
Despite low regulatory risk, many of these “legacy” Tech firms have underperformed alongside FB as stock correlations have spiked. Our report this week identified Technology stocks that have experienced the largest increase in correlation with FB and have underperformed both the market and their sector, in part due to investor use of macro products such as ETFs and futures. Examples include firms with little regulatory risk such as Buy-rated CSCO, NVDA, and GPN.
The bottom line: once Facebook and Google break away from the legacy positions as sector leaders in the current InfoTech and enter the brand new Communication Services group, what is left over in Information Technology will be a far less glowing example of rapidly growing stocks, which in turn will prompt an unknown number of investors to dump the sector.
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And now that we know Goldman's two main reasons to sell the stocks, here again are Bank of America's "10 reasons why global investors should reduce tech allocations in 2018":
- 1. Excess returns & fancy valuations: US tech is best performing sector in QE era, up annualized 20%; ex tech the S&P500 would be 2000 not 2600 today
- 2. Bubbly prices: US internet commerce stocks (DJECOM) soared 624% in 7 years at their peak, 3rd largest bubble of past 40 years (see chart above)
- 3. Fat market caps: US tech market cap ($6.4tn) exceeds that of Eurozone ($5.0tn); FAAMG+BAT market cap of $4.9tn exceeds Emerging Markets ($4.6tn).
- 4. Earnings hubris: tech & eCom companies currently account for almost 1/4 of US EPS (Chart 6); this level that is rarely exceeded, and often associated with bubble peaks; note there are currently just 5 “sells” out of 250 FAAMG recommendations
- 5. Politics: privacy becoming policy issue as equivalent to entire global population searches Google every 2 days; last year 1579 “data breaches” exposed 179 million records of personal names plus financial or medical data; pending US & EU regulation threaten 4% of tech revenue.
- 6. Wage disruption: IMF says 50% of the decline in labor’s share of income is attributable to technology (25% due to globalization); number of global industrial robots by 2020 will be 3.1 million (was 1 million in 2010)
- 7. Tech is cash-rich, tax-light: sector has $740bn of cash overseas (larger than all other sectors put together ($510bn); effective rate of tax on US tech companies is 16.9%, lower than the 19.3% paid across the S&P500
- 8. Tech most lightly regulated sector: just 27K regulations (Chart 7) for tech; by comparison manufacturing regulated by 215K rules, financial sector by 128K.
- 9. Tech & trade: US tech has highest foreign sales exposure (58%) of all US sectors
- 10. Occupy Silicon Valley: tobacco (1992), financial (2010), biotech (2015) industries illustrate how waves of regulation can lead to investment underperformance.