By Chris Matthews, MarketWatch
U.S. stocks remain well below the record highs set in mid-February, as investors are faced with the uncertain long-term economic impact of the coronavirus epidemic. But tech stocks have proven much more durable than the market more broadly, sparking a debate among investors and analysts as to whether this enthusiasm is justified or misguided.
Even as tech stocks had roared into 2020 at historically high valuations, the current economic downturn has left them relatively unscathed because investors see these companies benefiting from secular trends toward remote working, cloud computing and more robust telecommunications infrastructure, which have only been accelerated by the response to COVID-19.
“We think tech’s performance is sustainable,” said Victoria Fernandez, chief market strategist and portfolio manager at Crossmark Global Investments. “People are increasingly turning to tech solutions to solve business problems. We’ve added to Amazon.com Inc . /zigman2/quotes/210331248/composite AMZN +2.49% because of Amazon Web Services, we’ve added to Microsoft Corp . /zigman2/quotes/207732364/composite MSFT +2.28% and we put ServiceNow Inc . /zigman2/quotes/202729495/composite NOW +4.31% into the portfolios, all of this for the sheer fact that the cloud business is going to improve.”
The information technology sector has fallen just 2.6% year-to-date, compared with a 10.9% decline for the S&P 500 /zigman2/quotes/210599714/realtime SPX +1.60% and a 15.4% decline for the Dow Jones Industrial /zigman2/quotes/210598065/realtime DJIA +1.34% Another gauge of tech-company performance, the Nasdaq-100 /zigman2/quotes/210598364/realtime NDX +2.34% has gained 1.2% on the year.
Meanwhile, the economic conditions — like slow economic growth, low inflation and low interest rates — that helped large tech companies power the stock-market rally in the years leading up to the epidemic will continue to dominate in a post COVID-19 world, said Michael Arone, chief investment strategist at State Street Global Advisors.
“I want to own companies that can grow organically because in a low-growth environment, growth will be at a premium,” he said. “Tech companies generate twice the revenue per employee than the rest of the market, and they deliver four times the profitability. That’s where you need to be despite the fact that valuations are elevated somewhat.”
The Nasdaq-100 is trading at 26.4 times 2020 earnings, up from 18.98 in 2015, according to FactSet, compared with the S&P 500, which is trading at 20.9 times 2020 earnings, up from 16.55 five years ago.
Another catalyst for tech shares going higher is the receding threat of regulation, Arone said. “Prior to the pandemic, policy makers around the world were beginning to shine the regulatory light on these companies, but this has taken a back seat as governments focus on solving the crisis.”
Others are not as optimistic, given the record high concentration of the five largest companies in the S&P 500 index: Microsoft Corp . /zigman2/quotes/207732364/composite MSFT +2.28% Apple Inc . /zigman2/quotes/202934861/composite AAPL +3.75% Amazon.com Inc /zigman2/quotes/202934861/composite AAPL +3.75% Google parent Alphabet Inc . /zigman2/quotes/205453964/composite GOOG +1.17% and Facebook Inc . /zigman2/quotes/205064656/composite FB +2.12%
“The persistent performance of a handful of megacap stocks has supported the level of the S&P 500 index, but raised investor concerns about narrow market breadth,” wrote David Kostin, equity analyst at Goldman Sachs in a recent note to clients.
“Many market participants — ourselves included — have expressed incredulity at the fact that the S&P 500 trades at just 17% below its all-time high amid the largest economic shock in nearly a century,” he added “Below the surface of the market, however, the median S&P 500 constituent trades 28% below its record high.”
And while historically such periods of extremely narrow market breadth have lasted as long as 27 months, “eventually narrow market breadth is always resolved the same way,” Kostin wrote.
“Often, narrow rallies lead to large drawdowns as the handful of market leaders ultimately fail to generate enough fundamental earnings strength to justify elevated valuations and investor crowding. In these cases, the market leaders ‘catch down’ to weaker peers,” he added.
“In other cases, an improving economic outlook and strengthening investor sentiment help laggards ‘catch up’ to the market leaders. In both cases, on a relative basis the outperformance of market leaders eventually gives way to underperformance,” Kostin said.
Beyond the very largest and most successful technology companies, there has been an increasingly popular argument for treating software companies in particular as defensive stocks, despite their often not paying the type of dividends often associated with low-risk equities.
Proponents of this theory say that the growing importance of enterprise software to American corporations’ operations, plus the evolution of tech companies’ business models from software being a big-ticket deployment to a service subscribed to on a regular basis has insulated tech companies from economic downturns.
Robert Smith, founder of Vista Equity Partners, told Forbes magazine in 2018 that “Software contracts are better than first-lien debt…You realize a company will not pay the interest payment on their first lien until after they pay their software maintenance or subscription fee. We get paid our money first. Who has the better credit? He can’t run his business without our software.”
That thesis helped power tech names to higher and higher valuations in recent years, but Gavin Baker, chief investment officer at Atreides Asset Management warned in a recent Medium post that this thesis will be stress tested in the coming quarters.
He argued that small and medium enterprises that have been closed completely will not have money to pay any of their obligations, not debt servicing, rent, taxes nor software bills. Meanwhile, a widespread economic crisis gives software subscribers leverage, Baker argued.
“Over the near term, at a minimum, discounting is going to go up significantly to help end customers, to reduce churn and to help sales representatives hit quota — or miss by less,” he wrote. “Over the next few months, in a world in which mortgage payments, taxes and student interest payments are being deferred, I’m not sure that software companies will be able to insist on payment or that it would be wise to do so.”