2020: What Just Happened? Pt. 3
The Outsized Impact of Tech Stocks on the Market
COVID-19 and the Big Tech Swoosh
Part of the series: 2020: What Just Happened? A Stock Market Untethered
The effect of the COVID-19 pandemic has drastically impacted all companies’ operations in ways unique to their own: for some, to their benefit; and, for many, to their detriment. Government mandated “Shelter-in-Place” have restricted in person businesses, making normal operations nigh on impossible. On the other hand, e-commerce-based businesses that don’t rely on physical storefronts, have benefited as American consumer behavior has moved increasingly online and logistics fulfillment deemed essential.
While this day-to-day reality has shifted from novelty to the unending new normal for us as individuals, it has also had profound impacts on the stock market’s balance in 2020.
As not all sectors of economy have been affected equally during the pandemic, investors have piled into companies that have benefited from the economic shifts caused by COVID-19, while fleeing those that have suffered. This has caused the Stock Market to reflect America’s “K-Shaped” economic recovery, as investor demand for some sectors have surged while other have declined.
This “K-Shaped” economic recovery has accelerated an ongoing decoupling of the return performance for major US stock market indices. Specifically, tech-weighted groupings of stocks have widely performed better than most other sector indices not only in 2020, but over the last decade.
Illustrating this imbalance, the S&P Technology Sector index has delivered more than twice the return compared to a basket of all stocks (including tech stocks) over the past 10 years. This gap between tech and the rest of the market is not new, however.
In the Late 90s, the “DotCom Bubble”, in which excitement over the internet’s impact on society, drove up tech stocks. Currently, we’re in our second wave of technology driven decoupling, as we have moved increasingly online during the 2010s.
In the charts and discussion below, we’ll explore further the current divergence of tech stocks and contrast that to a previous run up of tech stocks during the DotCom Bubble, and also analyze how this has led to Tech’s outsized impact on the overall market.
A refresher: An index (plural: indices) tracks the performance of a basket of stocks or other securities. There are 4 primary* US equity market indices that draw the majority of investor attention on a daily basis.
- S&P 500 — Broad based index of 500 of the largest public companies in the United States, across various sectors and exchanges
- Dow Jones Industrial Average — A price-based index of 30 of the most reputable companies in the United States, across various sectors and exchanges
- NASDAQ Composite — Exchange based index of all companies (weighted by market capitalization) listed on the NASDAQ exchange, heavily weighted to information technology companies
- Russell 2000–-Broad based index of roughly 2000 small market capitalization ($300 million — $2 billion) companies in the United States, across various sectors and exchanges
The Rise of Tech in the 2010s
Over the last decade, the US has unabatedly shifted online. A key enabler to this trend has been the proliferation of smartphones — in the US, smartphone penetration grew from 20% in 2010, to 72% in 2020. As a result of this behavioral shift, the performance profiles of tech stocks and non-tech companies have diverged significantly.
Meeting high demand for software enabled commerce, the Technology Sector has attracted voracious investor appetite. This increased interest in tech stocks has pushed their value increasingly higher, far outpacing other sectors. 2020 was a prime example of this investor sentiment — the NASDAQ Composite level gained 43%, while the S&P 500 level gained 16% in comparison. Though shockingly amplified over the past year, this trend has actually been playing out over the past decade.
As can be seen in the performance graph above, returns for the four major market indices moved relatively tightly with one another from 2011 through 2013. However, since 2014, the NASDAQ Composite has largely decoupled from the other indices as investors have poured money into technology companies.
eCommerce Abound
In the 2010s, commerce shifted way from “bricks” (in person) to “clicks” (digital). Over the past year, these conditions have led to a huge surge in demand for online facilitated goods and services.
Census Bureau reporting on the composition of US retails sales highlights this drive. In Q3 2020, growth in E-commerce Sales was up 37% over the previous year, making up most of the growth in total retail sales, which were up 8.33% year-over-year in Q3 2020 — all in spite of the pandemic.
Companies that have benefited from this move online (think Zoom, Shopify, Doordash, etc.), have in turn pushed up valuations on the NASDAQ Exchange, home of the FAANGs. In 2020, the 100 largest companies on the NASDAQ saw a collective increase of 47.6% in value, whereas the 30 companies that make up the Dow Jones Industrial Average index (which includes Apple), returned 9%. In sum, COVID-19 has accelerated Tech’s separation from the rest of the market.
While many commentators have likened this period of sustained tech dominance to the “DotCom” price bubble of the late 1990s, the current run up feels more permanent as tech companies are now mature market leaders. Without any major shifts in consumer behavior, this gap could sustain into the foreseeable future.
Comparing 2020 with the DotCom Bubble
The NASDAQ Composite previously decoupled from the rest of the market back in the late 1990s, when there was a frothy market for internet stocks. With the widespread adoption of the internet on personal computers in the 1990s, hundreds if not thousands of internet-based companies (such as Pets.com and WebVan) held Initial Public Offerings (IPOs) and bolstered the performance of the NASDAQ.
Yet, many of these internet-based companies struggled to become profitable, and were either quickly delisted or acquired. Of the 15 largest tech companies listed on the NASDAQ in 2000, only 4 remain to this day, namely Cisco, Microsoft, Intel, and Qualcomm. The failure of so many internet based businesses caused investors to sour on Tech, bursting the “Dotcom Bubble”. Falling from its lofty heights, the NASDAQ Composite’s returns quickly returned to tightly tracking the other major indices.
How is the current decoupling different? Enter the FAANGs
The current run up in tech stocks is systematically different from that of previous tech bubbles. Versus the “DotCom Bubble”, the stock market of the past six years is driven by not only the higher premium investors put on tech stocks, but also by the growth of the fundamental financials and ubiquitous reach of tech enabled companies.
At the center of this contrast are the financial performance of “Mega Cap” (valuation of over $200 billion) tech companies such as Facebook, Amazon, Apple, Netflix, and Google, or the so called “FAANG” Stocks.
The main difference between the success of FAANG companies and their DotCom predecessors is business model maturity. While Amazon and Apple were already publicly listed during the DotCom Bubble, they are unrecognizably different companies now in terms of profitability. Reminder that in 2001, Amazon mainly sold books online, while Apple sold iMacs and had just introduced the iPod.
Financially, in 2001 Amazon and Apple generated cash flows from operations of -$119 million and $185 million, respectively. By comparison, in 2020, Amazon had a cash flow from operations of $38 billion, while Apple generated $70 billion. This is shocking growth that has been fueled by the maturation of the internet’s ecosystem and these two companies’ penetration into new markets, domestic and international.
The public listings of Netflix (2002), Google (2004) and Facebook (2012), all occurred after the bursting of the DotCom Bubble. These companies ushered in a remaking of entire business sectors, and have benefited from a rapidly changing advertising and media ecosystem. Whereas media and advertising were largely dominated by media conglomerates in the early 2000s, Google, Facebook and Netflix have changed the way we consume ads and media.
FAANGs’ Dominance Drives the Market
Since 2014, the FAANGs have collectively gained 610% in value, ascending to become some of the highest valued companies in the world. The rise of the FAANGs, along with other supercharged technology and software powered companies (NVIDIA, Tesla, Salesforce, Microsoft, etc.), has resulted in Tech having an outsized impact on the performance of all major indices.
Double clicking into how much of the market is driven by the FAANGs, we can look at what proportion of the major indices they make up. As of December 31st, the five FAANG companies alone accounted for roughly 32% of the total value of the NASDAQ-100, and 19% of all 500 companies in the S&P 500 (which also tracks the FAANG companies).
During the pandemic, all of the FAANGs have weathered the hits to the economy very well, with some having their best financial years ever. Investors rewarded these companies, and on average the 5 FAANGs gained 50.87%. The big get even bigger.
This dominant performance only increased the FAANG’s outsized impact on the markets and counterbalanced the negative performance of many smaller non-tech companies. This ultimately helped the major indices climb out of free fall in March, and created the “Swoosh-like” total market return in 2020.
While this has created the mirage of widespread recovery in the markets, in reality, the success of the FAANGs has masked a tale of two economies: one of prosperity and one of suffering.
Looking ahead, the pandemic’s systemic economic effects on consumer behavior could sustain or even increase the FAANGs’ dominion on the market, especially as the coronavirus still rages unchecked across the US. This could mean that the trend of two economic recoveries will sustain.
Unless the FAANG companies dramatically lose value in 2021 and are dethroned by non-tech companies, then it’s hard to see this divergence narrow. For right now, we’d say don’t hold your breath — in 2021, just like 2020, as go the FAANGs, so goes the entire market.
Up Next:
2020: What Just Happened? Pt. 4: K-Shaped Market Dynamics — Dissecting the Social Distance Economy
