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Consumer tech, software as a service, social media, cloud plays, gig economy stocks, digital payments — all of these areas and more like them have performed brilliantly over the past decade-plus.
They won’t perform brilliantly moving forward, though. They are the investment opportunities of the decade we left behind, not the one we are heading into. If you insist on buying technology and growth in the coming years, you will probably tread water at best, and it is far more likely you’ll be subjected to pain.
To understand why, we can look at Microsoft (MSFT), one of the all-time-great companies and an all-around great investment over the past nine years.
Microsoft is a world-beating technology juggernaut. It is run by a fiercely capable and strategically brilliant CEO, Satya Nadella. Its future in cloud services and many other areas looks bright. And yet, MSFT will most likely be a lousy investment in the coming years.
If you buy in today, you will almost certainly lose money on the stock in five years’ time, or languish in nominal terms and lose money after inflation.
Before we dig into why, it’s important to note that companies and industries can fall out of favor for long stretches at a time, sometimes a decade or more. This is what happened to Microsoft after its dot-com bubble peak in the late 1990s.
People forget that the dot-com era of the late 1990s was not just about internet stocks. It also led to unprecedented levels of overvaluation in more traditional blue-chip names, most prominently Microsoft (MSFT) and Coca-Cola (KO).
- Microsoft saw its peak dot-com-era valuation in December 1999 — then traded sideways to down for more than a decade and a half, taking almost 17 years to surpass its 1999 peak.
- Coca-Cola saw its peak dot-com-era valuation in August 1998 — and then, like Microsoft, traded sideways to down for nearly 16 years before overtaking its 1998 levels.
What caused these iconic blue chips to stall for so long? Did the business suddenly go bad?
No, the trouble was crazy valuations. Both KO and MSFT saw mind-blowing valuation run-ups in the late 1990s, to the point where Bill Gates was briefly worth $100 billion in July 1999.
When companies reach extreme valuations at the peak of a cycle, they can spend years — or even whole decades — working off the excesses of that extreme.
Take Microsoft today, for example.
- As of the March 29 close, MSFT had a price-to-sales ratio of 12.27 and a trailing price-to-earnings ratio of 31.89, according to Yahoo Finance.
- Those valuations are beyond extreme — and easily comparable to the extreme valuation Microsoft had in December 1999, before the stock stalled out for nearly a generation.
Fighting Valuation Compression Is Like Walking into a HeadwindIf you’ve ever tried to walk or jog in high winds, you know how challenging it can be.
When the wind is strong enough, you literally have to lean forward when walking against it — because if you don’t, the wind pushes you back and can even topple you over.
Big-picture cycles of valuation expansion or compression are like the direction of the wind. Sometimes they move in a favorable direction for investors — and sometimes they do the opposite.
- In periods of valuation expansion — when multiples like price-to-earnings ratios and price-to-sales ratios are growing — technology and growth investors experience a bullish tailwind. The valuation wind is at their back, helping to propel share prices upward, because every dollar of earnings is worth more as the multiple applied to it gets larger.
- In periods of valuation compression, however, the opposite condition takes hold. When valuation multiples compress, technology and growth investors face a fierce headwind. If the valuation is being compressed — meaning the price-to-earnings ratio and price-to-sales ratio is getting smaller — share prices will tend to fall or flatline, even if the company does well.
This is a real problem because when the macro cycle switches from valuation expansion to valuation compression, it doesn’t matter whether you are buying a good business. If the valuation multiple is in compression mode, the business can chug along and the share price can still go sideways or down, sometimes for years at a time.
The problem we’re describing here is even worse for tech and growth companies with negative earnings.
Take Airbnb (ABNB), a well-run company with an excellent business model.
Airbnb is well positioned to thrive as a global business in the years ahead. It has a durable competitive advantage due to worldwide network effects — to truly compete with Airbnb, you would need millions of properties on multiple continents, a very hard thing to replicate — and travel trends are favorable to Airbnb relative to the traditional hotel industry.
Still, though, the company has negative earnings — it is still burning cash for the sake of growth — and trades at a price-to-sales ratio of 16.87, per Yahoo Finance.
From a historical perspective, a multiple of nearly 17 times sales is beyond extreme, especially for a company with a $100 billion valuation.
It is so extreme, in fact, that if the ABNB share price fell by half — to a multiple of roughly eight times sales — it would still be considered expensive!
In favorable periods of valuation expansion, the multiple can go almost anywhere as investors take the attitude of “Who cares what the multiple is — it’s a great company and conditions are favorable.”
But that casual disregard for valuation is a two-edged sword, because the same logic turns brutal in periods of valuation compression.
If a fast-growing company can have literally any multiple in good times — because investors don’t care — that same multiple can be slashed by 50% in tougher times and still look pricey.
If the company is an excellent business and well run by smart management (as Airbnb seems to be) then some, but not all, of the valuation compression in a tough period can be offset by actual revenue and profit gains in the underlying business.
And yet, if the nosebleed valuation shrinks at a faster rate than revenues and profits grow, the favorable earnings results might only get investors a 20% decline in the overall share price versus a 50% one.
This is why bear markets can be rough, by the way: In bear market conditions, even companies that are doing well and growing their profits can see share prices flatline or decline for years on end, because the valuation multiple is traveling in a negative direction faster than the business is moving in a positive direction.
The Tech and Growth Decade Is OverOkay, you might ask, but why expect valuations in technology and growth stocks to go into compression mode for years on end?
Clearly, tech and growth stocks have been doing well for a long time — a solid decade or so, notwithstanding the rough waters of 2021 — so what would make such a difference now as to expect the valuation gear to be thrown into reverse?
To answer that question, it’s first important to remember that favorable conditions for technology and growth stocks are cyclical.
This shift in market conditions, from favorable to unfavorable and back again over time, also explains why valuation multiples tend to expand and compress like an accordion. In favorable conditions, valuation multiples tend to grow, with price-to-earnings ratios and price-to-sales ratios widening; then in unfavorable conditions they compress again, and so it goes in an ongoing rhythm.
Three of the primary drivers that favor tech and growth stocks — and encourage valuation expansion over a period of many years — are the presence of low inflation, low interest rates, and easy credit.
- When inflation is low, it makes sense to invest in projects with large paydays far off in the future. The less worried investors are about inflation today, the more they can focus on lucrative paydays five or 10 years out.
- When interest rates are low, it is easier to finance long-term projects. When interest rates are near zero and credit is widely available, companies can justify borrowing for almost any project, which in turn makes it easy for investors to fund speculative technology and growth ideas.
- When the yield is low on safe-haven instruments (such as money market accounts that offer a fraction of a percent), tech and growth opportunities become more attractive as investors “reach for yield” or otherwise seek ways to make money in a yield-starved world.
Now we are headed into almost the exact opposite conditions.
That is why the game is over for tech and growth stocks. The cycle is turning outright hostile for tech and growth, at a time when valuation multiples are high and likely to endure years of valuation compression.
This cycle will last a very long time — possibly the rest of the decade. Analysts who still insist on recommending tech and growth names, meanwhile, will be burning up investors’ money.
So is there anything you can do? Is there a way to still profit from what is coming?
Yes. Look to value stocks, commodities, and energy and precious metals. These will be areas of prosperity in the years ahead. The cycle is deeply favorable for them now.
The Bond Market Is Using a BullhornWe are headed into a period of rising inflation and rising interest rates. Such conditions are terrible for technology and growth stocks — and excellent for traditional value stocks.
You’ve likely heard that U.S. inflation is at 40-year highs, and that Russia is turning into a pariah state due to its actions in Ukraine, which is contributing to oil prices above $100 per barrel (with oil possibly on its way to $150-$200 per barrel).
What you may not know is that global bond markets are having their worst start to a year since 1949, because bond markets fall as interest rates rise.
Global bond markets are in free-fall because interest rates are finally rising in a meaningful way.
And interest rates are likely to keep rising, over a period of multiple years, because inflation levels are now painful for the West and the major drivers of inflation — like persistent shortfalls in the supply of energy, metals, and grains — are not going away.
Value stocks and commodities tend to do well in conditions that are the polar opposite to the conditions favoring technology and growth stocks.
- When inflation is rising, physical inventory becomes more valuable: As the price of oil and copper goes up, the value of oil reserves and copper in the ground goes up, favoring the valuation outlook for energy and metals producers.
- When cost inputs are rising, existing physical assets like factories and equipment become more valuable as the cost of building new plants becomes more expensive. The harder it is to replace a plant — due to severe price increases in the cost of aluminum, for example — the more a company’s existing physical plants are worth. The companies that benefit from this trend tend to be value stocks in the heavy-industry mold (as opposed to, say, asset-light technology stocks).
- When inflation is rising, cash flows in the future are less desirable because inflation eats away at the value, whereas cash flows in the present become more desirable because cash today is worth more than cash tomorrow. This favors companies that pay dividend yields, again tilting toward value stocks and energy and commodity producers.
- When interest rates are rising, speculative projects are harder to finance and investors lose their appetite for risky technology gambles, whereas projects making fat profits here and now (like high-quality mining or drilling operations) are favored for their money-making ability in a rising rate environment.
- When corporate profit margins are being hit by inflationary cost increases as the price of everything from fuel to grains to industrial metals goes up, one of the few places in the market where profit margins are fat and expanding are the producers of energy, grains, and commodities — the stuff whose price is going up — thus attracting capital to these industries.
- At the start of a transition away from technology and growth and back toward value and commodities, technology and growth stocks tend to still be wildly overinflated in terms of valuation even as value stocks and commodity names tend to be greatly undervalued relative to long-term historic trends. The combined result is like a tilted pool table, where the balls tend to roll away from the technology and growth corner pocket in the direction of the value stocks and commodities corner pocket.
For example, check out this multi-decade channel breakout in the U.S. Treasury 10-year yield:
With inflation at 40-year highs and the Federal Reserve locked into a hiking cycle — it will be forced to hike aggressively no matter what, even if a bear market or recession is the result — the U.S. Treasury 10-year yield has likely seen its all-time bottom, and is now attempting a second breakout from a multi-decade bearish channel.
Then, too, the Nasdaq Composite and the Nasdaq 100 index both triggered official bear market status (a 20% or greater decline from the highs) in recent weeks.
The Nasdaq going officially bearish was no fluke. It was further indication of the major transition from the tech-and-growth-favorable conditions of the 2010s — low interest rates, low inflation, and easy credit — to a harsher environment of rising inflation, rising interest rates, and tightening monetary policy, which benefits value stocks and commodity and energy plays.
Beyond the U.S. Treasury 10-year yield, further evidence of the sea change is found in bond markets globally, which have experienced levels of early-year turmoil in 2022 not seen since the implementation of the Marshall Plan (a massive American aid effort to restore postwar Europe) in the late 1940s.
In fact, according to Bank of America strategists — and we agree with this assessment — the “third great bond bear market” is likely now underway.
The first great bond bear market, per BofA, was from 1899 to 1920, lasting more than two decades; the second one was from 1946 to 1981, lasting three and a half decades.
That is a long time for interest rates to be rising — and for technology and growth stocks to be out in the cold. Do not “buy the dip” in such names, and do not listen to macro-blind analysts who advise you to buy.
Instead, look to energy, to industrial metals, to heavy industry and agriculture and precious metals; from a big-picture macro-cycle perspective, the upside in such areas is only just beginning.