Warren Buffett this week announced he had more than doubled his stake in Apple (Nasdaq:AAPL) and apologized to investors for missing out on Amazon (Nasdaq:AMZN) and Alphabet/Google (Nasdaq:GOOG). Presumably, had he been around in July 1720 (he wasn’t quite) he would also have apologized to investors for missing out on the bonanza of the South Sea Bubble. Buffett’s belated rush into the tech sector is about as good a sell signal as you can get.
Buffett has always said he does not understand tech, which naturally makes his vehicle Berkshire Hathaway (NYSE: BRK-A and BRK-B) underperform in extreme tech boom years such as 1999 and, apparently, 2016-17. It is thus extraordinary that he should change his view at a time when tech valuations are so high, especially as his only outstanding success since 1995 or so was the very non-tech Burlington Northern Santa Fe railroad, bought brilliantly close to the bottom of the market in 2009, and then riding the boom in domestic energy production.
There are a number of other signs that the bell may be ringing for the end of the bull market. The implied volatility of the Standard and Poor’s 500 Index (VIX) has reached its lowest level since 1993, suggesting a very dangerous level of complacency among market participants. The “unicorn” private tech companies that achieved such extraordinary valuations in 2014-15 are beginning to come to the public market, with valuations in most cases substantially lower than their peak. Given the amount of private equity money available for tech sector investment, that suggests that psychology is turning, and that investors can no longer be found to sustain tech sector valuations at their previous stratospheric levels.
Buffett’s own track record is stellar, but as a value investor. Today, there are no values in any sector of the U.S. market, and very few internationally. In 1999, I was living in Croatia, and made nice money buying Croatian shares on 2x and 3x earnings, when NATO was conducting a bombing campaign against neighboring countries and dropping the occasional stray bomb on Croatia itself (and on Sofia, Bulgaria, a full 50 miles across the Bulgarian border from the country NATO was aiming at.) I had more faith than did domestic Croatians that NATO would eventually stop bombing the neighborhood, and the situation certainly led to better and sounder bargains being available in Zagreb than in the ludicrously overpriced New York markets. Today there are no Croatias; even the more obscure and unfashionable emerging markets are on 10x earnings or so.
The reality is that Buffett’s mentor Benjamin Graham, who in his 1934 “Security Analysis” was highly critical of the false valuation metrics that had spread like bindweed through the 1928-29 boom, would be even more horrified by the simplistic thinking of many investment “experts” today. Buffett’s partner Charlie Munger called one of the most popular metrics of today, EBITDA (earnings before depreciation, interest, taxes and amortization) “horror squared” observing entirely correctly that for an investor to ignore a business’s deprecation is to ignore one of the business’s most significant costs, treating it as if all its assets were destined to last forever.
Apart from agreeing with Munger about EBITDA, Graham would point out that almost no companies today are trading at reasonable valuations, and that many companies, such as the Internet furniture retailer Wayfair Inc. (NYSE:W), are trading at very substantial valuations without ever having made a profit, or having any likely prospect of doing so. In 2000, Pets.com managed to get listed on New York without any semblance of a viable business model; in today’s market there are many such monuments to investor euphoria. It is not a question of proprietary technology that has yet to find a market; Wayfair sells home furnishings, a mature business not especially well suited to e-commerce, and its retailing software is presumably similar to most others.
Ever since the late 1990s, U.S. markets have assumed that traditional valuation metrics tethering asset prices to the ground no longer apply. That’s not surprising; since 1995 the Fed has encouraged this delusion, with ever more expansionary monetary policies. In the late 1990s tech stocks lost their basis in reality; in the middle 2000s housing and mortgage bonds became untethered, and now there is a strong case that we are in an “everything-bubble” in which assets of all kinds are floating in financial hyperspace.
However, the Fed has already raised interest rates three times (admittedly by a feeble ¼ point each time) and has given fairly strong indications it will do so again at the Federal Open Market Committee meeting next month. At some point, the market will stop dividing by zero in its valuation calculations, to produce potentially infinite valuations of loss-making companies. Admittedly, inflation is on a modest upward trend, so real interest rates are not rising, but we saw during the 1970s that the market is unsophisticated about inflation, and tends to discount by the nominal interest rate. To the extent this is so, even if real interest rates remain negative as inflation and nominal rates rise, at some point the teetering ziggurat of market valuations will topple, causing ruin around it.
Buffett’s sudden enthusiasm for the tech sector is thus especially ill-timed. The fantastic “unicorn” and ‘dekacorn” valuations achieved by private tech companies in 2014-15 now appear to be deflating, with several companies recently going to the public market at valuations below their previous private level, surely a sign of recognition that the party is very nearly over. Even Uber, the darling of darlings in the tech sector, is no longer held by anyone serious to be worth $65 billion.
The crony capitalist nexus between leftist companies like Google and Facebook and the Obama administration (of which Buffett himself was a part) has now crashed to the ground in electoral ruin. In a world where “Silicon Valley is leading the opposition” to President Donald Trump, tech valuations and indeed their businesses must be highly vulnerable to erosion. In many areas, it would only take one adverse ruling by one of the myriad regulatory bodies with which the U.S. economy is now infested to bring a tech behemoth’s earning capacity under severe strain. Much of the tech sector’s recent growth, and the entire business model of such stars as Tesla (Nasdaq:TSLA) has been built on favors from government; we must always remember that he who lives by the sword of government favoritism may very well die by it if the government changes.
Indeed, the tech sector’s entire political economic model comes into question; can it be rational for supposedly the economy’s fastest growing sector to support almost universally the party of heavy regulation and high taxes? The conflict of values between the supposedly “libertarian” ideals of the tech sector and the crony capitalist rent seeking that infests much of it may finally be producing the inevitable result. Far from being a beneficiary of Trump’s admittedly spotty and incoherent moves towards deregulation and lower taxes, the tech sector looks increasingly likely to be a victim of them.
President Trump wants the stock market boom to carry on throughout his term in office, but this looks almost impossible for him to engineer. Valuations are at unsustainable levels and weaknesses are appearing all over the economy, from real estate to the tech sector. While Trump’s policies may well bring manufacturing back to the heartlands, it is decades now since the companies concerned formed a significant part of the overall market’s capitalization. The tech sector’s weaknesses and the gradual rise in interest rates both seem likely to bring the market back to earth sooner rather than later, and the result won’t be pretty, although if Congress and President Trump refrain from meddling (a vain hope, surely), it may be short-lived.
Warren Buffett’s capitulation to the joys of Amazon and Google is thus a sign of a market peak, an indication that the dean of value investing has abandoned the first principles of value assessment. We should make our deployments accordingly.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)