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US tech sector: Continued run-up or correction coming?

The investment case for stocks in a low interest rate environment and an era of disruptive technology.

Since the infamous “dotcom” meltdown nearly two decades ago, investors have questioned any sort of extended run-up in tech-sector stocks. Stephen Dover, executive vice president and head of equities at Franklin Templeton Investments and chief investment officer, Templeton Emerging Markets, explains why he thinks the rise we are seeing today is different from that of the 2000s.

MONEYWEB: The US tech sector has been on an incredible run. What’s your take?

STEPHEN DOVER: We have seen big rises in technology, the famous being the tech bubble in the early 2000s, but there was a bubble in 1974, as well. If someone came to you and said, “I have this great idea, I am going to start a global online taxi company” would you say it’s a technology company or is it a taxi company? I think we are in a different situation than in the past and I think that probably the biggest difference is this disruption, and the second difference is that these companies  actually have cash flow and earnings. And at this point, they don’t look greatly overvalued like they did in the tech bubble in early 2000s because there are earnings there as well.

MONEYWEB: What is the difference between the early 2000s and now?

STEPHEN DOVER: There were a bunch of companies that actually had no earnings and had no real value. If I can be slightly technical, I would say the way most analysts value companies is by looking at a discounted cash flow or at discounted dividends and most of those companies in the early 2000s, couldn’t be valued that way. So you had what was called the terminal value. You presumed that after 20 years it was going to have a whole lot of value and you discounted that back and that was valuation. We are not in that situation at this point, we are really looking at companies that have cash flow or at least have the potential to have cash flow.

MONEYWEB: With the disruption in technology, do you think it changes the timeline of these steep market rallies?

STEPHEN DOVER: With technology stocks, we are looking at a different industry and we are looking at different opportunities and monopoly power, to some degree. So what do you disrupt? You disrupt areas that have high profit margins and that’s really where these companies have gone, and so by definition a lot of opportunities there. A way to look at and think about valuations, rich or not rich, is to see price-to-earnings ratios as an inversion. They’re very similar to interest rates and when you have low interest rates something in the future is worth more because it’s discounted at a lower interest rate. Because of that, you can’t really compare current valuations to past valuations.

So living in a world in which we have a lot of money supply, in which we have fairly low interest rates and even interest-rate projections to rise are pretty benign, that means that valuations for earnings streams are worth more than they would have been worth in the past, so that is probably the primary driver behind why markets have performed. Also, when you have very low interest rates, but you have higher earnings streams, share buybacks are worth more than dividends and that’s been a big part of the market as well. The markets actually shrunk. There are fewer shares, fewer companies in the market than there have been over the last say 20 years and despite initial public offerings and new companies.

The third [dynamic] is really the political environment. We are in an environment that is generally very positive for business and if anything, it looks like there’s more upside [in], for example, potential tax cuts, than there is a downside. So it’s a pretty benign environment and that’s a situation where you end up having markets at all-time highs.

MONEYWEB: How long do you think the rally in tech stocks can last?

STEPHEN DOVER: We have to look at what has happened in this market. There’s been rotation in the sense that there have been sectors that have performed very well, most notably the technology sector, and sectors that have had terrible rollovers, such as the energy sector, and at different times the health care sector and some of the other sectors. So that’s healthy for a market. A benign market can happen for a long time. In this particular economy, in the United States at least, we have had one of the longest recoveries than we have ever had, but we have also had a weaker recovery than we have ever had, too.

There is some argument that a weaker recovery can last a longer time than a strong economy.

There could be a political situation, it could be a terrible situation in Korea, it could be trade war with China, it could be a political incident in the United States, because investors are pricing in, if you will, a very positive environment. So if it doesn’t — if earnings don’t keep going, if interest rates don’t stay low, then there’s a possibility that there could be, at a minimum, a correction or perhaps a severe correction. I would say that the likelihood of a correction over the course of the next couple of years is probable and that shouldn’t really disturb long-term investors.

MONEYWEB: Do you think some sort of correction in the market would also be different to what we have experienced in past cycles?

STEPHEN DOVER: It’s hard to say. It would surprise me if we didn’t have a 5% or 10% pullback; that’s the history of the markets and markets get ahead of themselves. I think it would probably be healthy for the market. Earnings are a big protection against a big meltdown and even if you look at technology stocks on a P/E ratio, they are sort of at 18-19 P/E ratio now. They have decent returns on equity as opposed to 2000 where they had P/E’s of 50 or 100.2 There still are some of those out there, and they would be at risk.

MONEYWEB: What investment approach should investors take?

STEPHEN DOVER: For most people, particularly people who are younger, the biggest part of their portfolio is actually their earnings streams, their savings over a period of time. When you take that into account, it changes the risk profile of how you should invest.

I certainly would not want to chase the market at this point and wouldn’t want to chase those more expensive stocks at this point. But where retail investors make their mistakes is trying to time the market and get in and out of the market. It’s probably not a good time to rush into the market, but I would be very careful about getting out of the market at this point.

Brought to you by Franklin Templeton.

  1. Source: Bloomberg LP, based on S&P 500 Information Technology Index forward and trailing price-to-earnings (P/E) ratios. The P/E ratio is a valuation multiple defined as market price per share divided by annual earnings per share. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges See www.franklintempletondatasources.com for additional data provider information.
  2. Ibid.

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