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Abu Dhabi, UAEWednesday 12 December 2018

Time to take profits on US tech stock double-bubble

US stock valuations also look way over the top even by the world-class standards of American share promoters

From a chartist's perspective major US markets have put in a classic double-top formation this year. AFP
From a chartist's perspective major US markets have put in a classic double-top formation this year. AFP

Buying low and selling high only ever made investors rich.

It’s a simple maxim. But even the most intelligent of investors get this wrong and sometimes badly so.

However, you don’t often see this happening so clearly as you do now in US stock markets where those hanging on for even higher prices in markets close again to record highs are risking a great deal more in losses to the downside than any remaining upside profits.

From a chartist's perspective the major US markets have put in a classic double-top formation this year after a record long bull run. After this kind of chart pattern the next step is usually a classic deep correction.

US stock valuations also look way over the top even by the world-class standards of American share promoters.

Consider the long term Cyclically Adjusted Profits to Earnings (Cape) ratio, a well-adjusted guide to market valuations. It’s long-term average for the S&P 500 is 18. Today is it 33.

For individual stocks their Cape ratio is off the charts. Take Amazon checking in at 215-times, or Netflix at 264-times earnings.

Then again you could look at the so-called Buffett indicator favoured by the eponymous investor that compares total US stock market capitalisation to GDP.

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It now stands at 138 per cent versus only 105 per cent in 2007 before the last crash, and 137 per cent in 2000 before the dot-com crash.

You might say, "Ah but S&P 500 profit margins of 11.7 per cent in the second half off 2018 were the second highest in history."

Okay, so companies have also now maxed-out on profits, throwing everything but the kitchen sink above the line.

How long can such peak of cycle profits continue? Tax cuts and profit repatriations have pushed company profits as high as they are going to go. Few analysts argue otherwise.

This exponential profit growth is most evident in the top six tech stocks - Apple, Amazon, Google, Microsoft, Facebook and Netflix - with a stunning 289 per cent combined profit spike in the first half of 2018.

Is it sensible or rational to think an already huge company like Netflix - its market capitalisation bigger than the whole beleaguered Turkish stock market - could possibly be worth 264 times its peak profits?

How could this happen you might well ask? True it is not just investor exuberance at work here.

These six tech giants have accumulated total debt of an eye-watering $588 billion largely from share buyback schemes to take advantage of cheap debt to boost their stock prices.

That’s a bubble on a bubble, a double-bubble. If you have got this far with the tech share boom perhaps now is the time to consider taking your profits and running for the hills.

The obvious time-bomb ticking in the corner is rising US interest rates and the Federal Reserve’s declared aim to get them higher to counter rising inflation and give savers a return on their money.

American investors seem to have forgotten that "Don’t fight the Fed" is a rule that also applies when the Fed changes direction.

For it has been the continuation of ultra-low interest policies for the past decade that has brought stock market investors their current bonanza, and a totally contrary force is now present as interest rates increase.

At the end of last year the Federal Reserve switched from easing to tightening its monetary policy. But it is doing so gradually and the real impact has not been felt yet.

Still on some estimates by the end of 2018 there will be $900bn less in central bank liquidity from the Fed and European Central Bank than in 2017, and the squeeze will continue into next year.

Dial back to the past two examples of stock market crashes from such extremely overvalued levels and you get an idea of what is to come next.

In 2000-2 the S&P 500 lost 51 per cent of its value; in 2007-9 it dived 58 per cent. Of course, the more overvalued individual stocks lost a great deal more value.

Do you want to be left like the guys who bought Bitcoin at the end of last year who are now sitting on huge losses.

To be fair, companies like Apple will not see their value go to zero like a thousand crypto-currencies this year. But you could still be able to buy back Apple at half-price and that might be a bargain.

It is not as though interest rate rises are the only steamrollers coming down the road. US President Donald Trump’s trade war with China and anybody else who annoys him is hardly good for global business.

Look how Turkey got smashed earlier this month by a sudden rise in tariffs that threw its already shaky economy badly off course.

Turkey might only be 1 per cent of the global economy. But in terms of global banking exposure it is similar in scale to Lehman Brothers whose collapse precipitated the last global financial crisis.

The main argument for holding US stocks is that valuations have pushed higher and higher and it is impossible to know exactly when and where this process will stop.

However, this summer feels very much to me like the summer of 2007 when it was still possible to cash out before the global financial crisis struck but the first warning signs were already evident.

For current anxieties about Turkey perhaps think more the 2007 troubles of Bear Stearns or Northern Rock as a comparison than Lehman Brothers; these early tremors of the approaching global crash were worrying but dealt with effectively.

If you had calmly folded your hands and cashed out in the summer of 2007 and sat out the crash in cash, treasuries and gold then you would have still been standing to pick up the bargain "devil’s bottom" of 666 in the S&P 500 in March 2009.

Maybe this is you today, and you have more than quadrupled your money since that time. If so then it could be time to consider repeating a winning formula.

Peter Cooper has been writing about Arabian Gulf finance for two decades