Between the generally adoring attention Silicon Valley start-ups receive in the media and the blistering pace of tech stocks since the Great Recession, many investors wonder if they have missed out or can still reap great rewards. The answer may be both.
There’s no doubt that the fundamental shifts in computing we’ve seen during the past decade underpin the tech sector’s consistently positive performance in the stock market. Many of those changes we’ve outlined here, including cloud computing, expansion of wireless network applications, software as a service, and the internet of things.
And while those trends have matured, they aren’t over.
Despite these fundamental reasons to believe tech stocks have an investment-worthy future, there are a few significant reasons to be wary—including the emergence of passive investing and its distortion of the market by increasingly piling increasing amounts of money into the leaders.
Elliott Gue breaks this down in detail in The Dumb-Money Bubble, but the basics are as follows. Most exchange-traded funds (ETF) index relative to market cap, so the largest companies receive the most dollars when you buy the ETF. That translates to more than $30 of every $100 invested into the SPDR S&P 500 ETF going to the top 20 holdings. And less than $10 goes to the smallest 250.
The immediate effect is that the stocks of the largest capitalized companies climb higher and increase the capitalization further. That makes it hard to focus on fundamentals and expect sizable returns for small- and mid-cap companies.
The longer-term effect occurs when the market turns direction. Those same skewed inflows that pushed the largest-cap stocks higher for longer become skewed outflows. And that means everyone’s favorite companies, including Alphabet (NSDQ: GOOG), Amazon.com (NSDQ: AMZN), Apple (NSDQ: AAPL), and Facebook (NSDQ: FB), are vulnerable to disproportionate downside if investors’ enthusiasm changes to doubt.
Another concerning signal is the simple length of the current market rally. In Time for a Hedge, we make it clear that although a bear market isn’t on the horizon, a pullback could be. After all, there’s an average of two or three 5 to 10 percent pullbacks each year–in only 10 percent of years since the 1930s has the market avoided a correction of this degree. And 2017 has featured only two relatively small moves lower, one in March and one in May.