Could Value Stocks Cushion A Tech Stock Tidal Wave?
May 24, 2018

Could Value Stocks Cushion A Tech Stock Tidal Wave?

I felt a tremor while on a holiday in northern Thailand. It was December 26, 2004. Two of my friends, enjoying Christmas in Phuket, would soon be trapped in an elevator that was filling with seawater.

Earlier that morning, the ocean was calm‚ but the waters receded. Onlookers ran towards the retreating shore. Some reportedly picked up flapping fish. As the water rushed away, more people walked towards it. That’s one of the scariest things about a Tsunami. It can warn us. But many people still move forward, as if in some kind of trance.

Perhaps it’s grotesque to compare what happened that day with a tech stock crash. But when it comes to human behavior, the two can be similar. When stocks soar faster than business earnings, it’s like receding water. Mesmerized by easy gains, investors rush the beach. It’s like when investors chased tech stocks in the late 1990s. The gap between stock prices and business earnings continued to widen, yet many investors still ran forward.

By October 2002, the tech-heavy Nasdaq 100 fell 78 percent from the peak of its giddy wave. Unfortunately, tech stocks might be ready to punish us again. As they did in the late 1990s, prices have detached from their business earnings. It isn’t as extreme as the previous dotcom bubble, but it’s still looking scary.

As investors, we need to keep things simple. Build a diversified portfolio of
low-cost index funds. If we’re employed, we should add money every month and rebalance once a year. But trouble often lurks where there’s seemingly easy money.

Some people ask, “Why would I buy a total stock market index when this tech stock index produces better results.” They might look at Vanguard’s Information Technology Index (VITAX). Over the five years ending May 3, 2018, it averaged a compound annual return of 19.94 percent. That compares with the S&P 500, which averaged a compound annual return of just 12.40 percent. The technology index’s year-to-date returns also look lovely. Over the first five months of 2018, it gained 5.64 percent. By comparison, the S&P 500 has dropped about 1.1 percent.

But we shouldn’t get pulled towards a receding shore. Today, the world’s seven largest businesses, measured by market capitalization, are all tech stocks. They include Alphabet, Apple, Microsoft, Facebook, Amazon, Tencent and Alibaba. Investors’ optimism has continued to push their prices even higher. Research Affiliates’ Rob Arnott , Shane Shepherd and Bradford Cornell say, “Never before has any sector so dominated the global roster of largest market-cap companies.”

Their PE ratios are also Tsunami warning sirens. The world’s seven largest tech stocks sport a median PE of 43.89 times earnings.

The World’s Seven Largest Stocks Sport Sky-High PE Ratios

Company Trailing PE Ratios Industry
Alphabet 57.64 Technology
Apple 17.43 Technology
Microsoft 77.24 Technology
Facebook 32.26 Technology
Amazon 257.28 Technology
Tencent 41.39 Technology
Alibabi Group 43.89 Technology
Group Average 75.30
Group Median 43.89

By comparison, the 21 largest holdings in Vanguard’s Russell 1000 Value Index Fund have a median PE ratio of 21.06 times earnings.

That’s why, as the tech sector soars, some wise investors are running the other way. They’re selling growth indexes in favor of value stocks.

When growth stocks drop, value stocks can be a cushion. For example, a $10,000 investment in large-cap growth stocks in January 2000 would have dropped to $6,510 by December 31, 2002. But the same $10,000, invested in large-cap value stocks, would have dropped to just $9,784.

Investors shunned value stocks during the 90’s dotcom rage. History might not repeat, but as Mark Twain once said, it certainly does rhyme. Once again, as growth stocks roar, value stocks get ignored.

But value stocks might be the best deal going. According to Columbia finance professor, Kent Daniel, when compared to growth stocks, value stocks are cheaper than at almost any time in history. In an interview with Mark Hulbert, Daniel said the typical value stock is usually one-third cheaper than the typical growth stock when comparing PE ratios. In 2017, however, he said the typical value stock was fifty percent cheaper compared to the typical growth stock. Over the first five months of 2018, that gap has widened further.

It makes value stocks the safer hill beside the beach. As the waters recede and the tech wave mounts, which direction will you run?

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