Tech stocks: bubble, bubble, toil and trouble?

History suggests no market fashion or trend persists indefinitely

Investors should avoid the broader US market and be especially wary of certain technology stocks that are, like bitcoin and controversial electric car maker Tesla, "well into bubble territory".

That's according to billionaire investor Rob Arnott, who helps manage $184 billion (€164 billion) at the firm he founded, Research Affiliates. Last year, in a paper that was the most-downloaded ever published by the firm, Arnott warned bubbles were occurring in parts of the global technology sector, in Tesla and in the cryptocurrency world. He remains concerned today, as evidence by the title of his latest paper, Bubble, Bubble, Toil and Trouble.

Arnott defines a bubble as having two characteristics. Firstly, it must have an excessive valuation indicating it has little chance of generating positive returns relative to bonds or cash. Secondly, buyers are disregarding the question of valuation, instead buying based on a popular narrative and assuming they will be able to sell it on to someone else at a higher price.

Bitcoin, which had already begin its epic collapse by the time Arnott’s original paper was published in April 2018, has staged a huge recovery this year, almost tripling in the first half of the year. Although it remains at roughly half its December 2017 peak, “plenty of bubble indications” remain, says Arnott, who says buyers’ expectations of higher future prices rest not on valuation but “solely on the hope” someone else will take take it off their hands at a higher price.


Like bitcoin, Tesla has tanked since 2018, losing a third of its value this year alone. The market outlook for a bubble asset can switch dramatically once it loses its “magic”, says Arnott, who points to Morgan Stanley recently slashing its worst-case scenario for the stock to $10 (a far cry from the $379 target price it slapped on Tesla in 2017). Despite heavy share price falls, Tesla’s valuation remains “well above that justified by even optimistic expectations of future cash flows”, and investors should continue to avoid the stock.


The outlook for US technology stocks is more nuanced. Apple and Microsoft's near trillion-dollar valuations rest on "aggressive, not implausible, assumptions". Others, such as Amazon, "might or might not currently qualify as bubble stocks; we could make the case either way". However, like Tesla, stocks such as Netflix, Twitter and Chinese giant Tencent "all arguably qualify as being in bubble territory" and some may even qualify as a "zombie" company that needs new capital just to pay the interest on its debt. Most of the Fanmags – Facebook, Amazon, Netflix, Microsoft, Apple, and Google – are "trading at valuations nearly as rich as they have ever traded".

Bubble-level expectations demand near-perfect execution, says Arnott, and recent corrections – the Fanmags fell into bear market territory in the last quarter of 2018 and lost almost 15 per cent of their value in May, when the S&P 500 slipped 6 per cent – illustrate just how sensitive a stock is when it is “priced to near perfection”. Tech declines in May should be viewed “not as the end of the story, but as another warning as to what can and likely will happen”. That warning seems prescient; tech stocks plunged again this month following another eruption of market turmoil.

Arnott’s thesis is that it’s not enough to steer clear of tech stocks. Indices such as the S&P 500 or the Russell 1000 are weighted by market capitalisation; the more valuable the company, the bigger it impacts the indices. The Fanmags now account for more than 14 per cent of the Russell 1000, almost double their 2014 weighting, so index investors are too exposed to overvalued tech stocks.

“As bubble technology stocks have come to dominate the world’s list of largest companies”, he cautions, “cap-weighted indices are making de facto bets that these growth-oriented companies can increase their valuations in the face of a slowing economy”. Sceptics would say Arnott is not an impartial observer when it comes to market-cap weighted indices; Research Affiliates has pioneered alternative indices weighed not by market capitalisation but by fundamental measures such as dividends, volatility and valuation.


Aside from recommending such indices, Arnott says investors should look for “anti-bubbles” – undervalued assets resting on implausibly pessimistic assumptions. They include emerging markets, in particular state-owned enterprises (SOEs) in emerging markets; a basket of SOEs trade at a discount of about 35 per cent to emerging markets, which in turn are significantly cheaper than the expensive US market.

Long-term investors should also be eyeing Britain, where Brexit-related turmoil is “potentially creating an anti-bubble opportunity”. The MSCI UK index offers a dividend of 4.52 per cent, even higher than the aforementioned basket of emerging-market SOE stocks, while valuations indicate UK stocks are trading at a 25 per cent discount to global indices. Brexit “would need to destroy quite a bit of value” to nullify this discount. Investors who wait for clarity will miss the opportunity, says Arnott, who recommends investors average into the UK stock market.

Bubble stocks could keep rising, of course, and Arnott admits prices can soar higher and longer than one might imagine. Additionally, some bubble stocks, such as Amazon during the dotcom era, mange to justify even the loftiest of expectations. “Implausible is not impossible!”, says Arnott. “There will always be counterexamples.” Nevertheless, stocks such as Amazon are a rarity, the exception to the rule; Arnott notes only one of the 10 largest tech stocks in 1999 (Microsoft) went on to beat the S&P 500 over the following 19 years.


Some investors could take issue with Arnott's portrayal of tech sector froth. Legendary value investor Warren Buffett now owns about 5 per cent of Apple, making it Berkshire Hathaway's second-largest stock position. Filings show Berkshire has also been buying shares in Amazon, while Buffett has said he regrets not buying shares in Google parent Alphabet.

As for the broader US market, it trades on 17 times forward earnings; according to JP Morgan's latest quarterly Guide to the Markets, that's only slightly above its 25-year average, a picture confirmed by various other valuation measures. Respected voices such as Arnott, value investor Jeremy Grantham and Nobel economist Robert Shiller have been cautioning for most of the last decade that the US market looks expensive relative to its global counterparts, but the US has defied the doubters and continued to outperform over that period.

Even if Arnott is right about bubble valuations in the tech sector, it doesn’t necessarily follow things will turn around any time soon. Alpha Architect founder Wesley Gray, a quantitative money manager and value investor, recently tested a seemingly “crazy” strategy of buying expensive stocks trading at more than 10 times their revenues. Incredibly, it has outperformed stock markets over the last 10 years. This persistence, coupled with the chronic underperformance of value strategies over the same time frame, has led many to question if value investing is dead.

Nevertheless, while timing the markets remains a near-impossible game, history suggests no market fashion or trend persists indefinitely. Avoiding bubbles and seeking out anti-bubbles remains a wise idea, says Arnott, and tomorrow’s winners may look very different to today’s. “As is so often the case,” he says, “the promising investment opportunities are not the popular and beloved assets of today, but are the ugly ducklings, the unloved, feared, and even loathed assets.”