Recent movements in the Tech Sector has the market questioning if we are headed for another Tech bubble, but should you be worried? Mark Hulbert had an article in Barron's expanding more on the subject.
"Worried about a tech bubble? Don't be" MARK HULBERT, BARRON'S – 06/27/2018
Some investors, worried that the technology sector was in bubble territory, were biting their nails Monday as the Nasdaq Composite plunged by as much as 2.8%. They can relax. The tech sector is not currently forming a bubble.
That’s the conclusion I draw after applying to that sector the criteria devised by a major academic study into the predictability of bubbles.
The study, entitled “Bubbles for Fama,” which is forthcoming in the prestigious Journal of Financial Economics, was written by Robin Greenwood, a finance and banking professor at Harvard Business School and chair of its Behavioral Finance and Financial Stability project; Andrei Shleifer, an economics professor at Harvard; and Yang You, a Ph.D. candidate at that institution.
The study’s title refers to Eugene Fama, the University of Chicago professor and Nobel laureate who is perhaps the most prominent of the many who have argued over the years that bubbles could not be forecasted.
This new study, in contrast, found that certain criteria could be used to forecast industry bubbles, which the authors define as beating the stock market by at least 100 percentage points over a two-year period followed by at least a 40% drop over the next two years.
The tech sector doesn’t come close to satisfying those criteria. Instead, S&P’s Technology Select Sector index is only 36 percentage points ahead of the broad market over the past two years, according to FactSet.
One of the most predictive of these criteria is the magnitude of price appreciation. When a sector beats the market by at least 100 percentage points over a two-year period, for example, the odds of a 40% decline over the subsequent two years—the bubble bursting, in other words—rises to about 50%. When that market-beating return gets as high as 150 percentage points, the odds of a subsequent crash rise to 80%. And when the two-year return is much higher than that—a very rare phenomenon, to be sure—a crash becomes “nearly certain.”
An example of how this can be used in practice came late last year with bitcoin, when its trailing two-year return was more than 4,000 percentage points greater than the stock market’s. Upon applying the Harvard study’s criteria to the cryptocurrency, I concluded that the odds of at least a 40% drop were greater than 80%. Bitcoin is currently some 68% below its December 2017 high.
The tech sector now is hardly similar to bitcoin last fall. The Harvard researchers have found that the sector’s two-year market-beating return of 36 percentage points is not associated with a significantly increased probability of a crash.
The researchers also examined whether other indicators could be used to identify a bubble, and found several that had value once a trailing two-year return reached a high enough level. These other indicators include above-average price/earnings ratios and an acceleration in the rate of price appreciation.
It’s worth noting that, even though the tech sector’s trailing two-year return isn’t high enough for these other indicators to formally come into play, they still aren’t ringing any alarm bells right now. The Technology Select Sector index’s forward-looking P/E, for example, currently stands at 18.37, according to State Street Global Advisors—only marginally higher than the comparable P/E for the S&P 500 of 17.36, according to Birinyi Associates. At the peak of the internet bubble in March 2000, the tech index’s P/E stood at 51.01.
Nor does the tech sector ring the price- acceleration alarm bell. The tech index’s trailing 12-month return is 24.9%, according to FactSet, which is actually lower than the 35.4% return the sector produced over the previous 12 months.
What about individual tech stocks? Though the Harvard study didn’t analyze whether their criteria worked in identifying bubbles for individual equities, Greenwood told Barron’s that he wouldn’t be surprised if they did have some applicability.
Currently, two of the so-called Faang stocks meet the price run-up criteria specified by the study: Amazon.com (AMZN), which has beaten the S&P 500 over the trailing two years by 105 percentage points, and Netflix (NFLX), which has beaten this benchmark by 301 percentage points. Both also have forward-looking P/Es in the triple digits, and both have exhibited a sharp acceleration in price appreciation.
If one assumes that the Harvard study’s bubble criteria apply to individual stocks, these two appear to be vulnerable to a crash—even if the sector generally does not.
Of course, none of this amounts to a guarantee that the tech sector won’t experience a crash. Anything is possible. But saying that it is possible is a lot different that claiming it is probable on the basis of applying objective criteria that have a good historical record at forecasting a crash.
In this regard, Greenwood points out that he and other finance academics are frustrated by the abandon with which commentators throw around the term “bubble.” Many of those commentators haven’t even bothered to propose a precise definition of what a bubble is, much less devise a set of criteria that has a decent forecasting record.
Needless to say, the tech sector could very well produce disappointing performance in coming months. But declaring that a sector is forming a bubble surely means more than saying that it will be a poor performer. The burden of proof is on those who think there is a tech bubble to make their case for what this something more entails.-