Is technology the new market risk?

Posted: 19th May 2017

By: Michael Lee

Overview

“Waken up in the morning by the alarm on iPhone, before rushing to check unread Facebook messages, while googling about today weather” is gradually becoming the typical way to start off a day for many. As technology becomes increasingly ubiquitous and indispensable to human, businesses and even the economy, the question regarding its necessity and value to the society remains debatable. For example, as much as Facebook might have enhanced our virtual communication channels and connected billions of people around the globe, certain books such as “Alone Together” by Sherry Turkle suggested social media’s negative impacts on real human interactions. However, the financial market seems to be more inclined towards the benefit of technology with technology companies occupying the top five positions in the S&P 500 by market capitalisation in May, 2017 and these top technology powerhouses, Apple, Google, Microsoft, Amazon and Facebook already accounted for approximately 12% of S&P500.

Source: Yahoo Finance

Technology Sector

The role of technological innovation has been fundamental to human civilisation and the quality of life, with at least four major technological revolutions in the last 200 years, including Industrial, Technical, Scientific-technical and Information-telecommunication revolutions. The nature of these changes are disruptive to existing industries and create opportunities in nascent fields, thus innovation is usually coined with terms “creative destruction” and “disruptive”. The modern technology firms are no exception to a high degree of disruptiveness and volatility, as firms and competitors continue to invest in new research and development to lead the direction of technological trends and in some cases, reshape the entire existing technology landscape. Two notable examples include the rise of Facebook to replace other social media sites such as Myspace and the way Google eventually dominates the search engine industry. However, the complexity and unpredictable nature of technology has also led to different crisis, such as the mispriced, inflated valuation of technology stocks by the stock market in the dot.com bubble, as well as mobile giants misinterpreting the technological development, in the case of Nokia. This shed light on whether the domination of technology behemoths in S&P 500, which is generally representative of the US equity market, is a sign of another technology bubble or an emerging trend towards technology-driven economy in developed nations.

Valuation of technology firms

Whether the rise of technology companies spells financial bubble or the rise of technology-driven economy, the financial market plays a significant role in both creating and stabilising risks. When markets are efficient and reflect the real economy, it enables firms and individuals to reasonably price different assets and allocate their resources more efficiently. However, mispricing by markets could also lead to economic value destruction. Three potential reasons behind the recent rally in the valuation of major technology firms in S&P 500: 1. The characteristic of monopoly power, unique value proposition and massive potential markets, often observed in successful technology firms generally translate into favourable financial returns, as measured by benchmarks such as ROE, ROIC and revenue growth. 2. Technology powerhouses have found ways to systematically monetise their technology and create sustainable business models, in contrast with the dot.com bubbles in 2000, where technology start-ups were less experienced and knowledgeable about monetising the internet. This potentially indicates a smaller degree of volatility and risk. 3. The financial market has become more efficient in valuing technology by building different models based on principles such as real option pricing, in addition to the traditional net present value approach. Despite of the subjectiveness around the valuation of technology firms, the transition towards a technology-driven economy seems inevitable.

The impact of emerging “Mega cap” technology companies on market risks

Market risks are risks that cannot be diversified and the majority of risky assets are affected by them. As technology starts to drive a larger portion of economic activities in a society, the risk of the technology sector would inherently contribute to the market risk, proportionally. In other words, in this technology-driven economy, the increasing reliance of the majority of firms and individuals on technology as necessity means that the financial performance of the technology sector is equivalent to a big part of the economy. Perhaps, if there was a day when people stopped using iPhones, Facebook, Windows and Google all together, it would probably indicate a serious crisis. The table shows the statistical analysis of these five technology firms and S&P 500 over the past 5 years. It is clear that the standard deviation which measures the volatility of a stock is higher than S&P 500 for the top five technology firms and their beta is generally higher, except Facebook, implying their tendency to amplify the movement of the market. Due to the diversification of an index, S&P 500 has a Sharpe ratio of 0.15, exceeding those of Apple, Microsoft and Facebook, except Amazon. However, in terms of absolution returns, all of the technology companies outperformed SP 500 by a strong margin.

Therefore, there is a strong likelihood that the increasing weight of technology firms in S&P 500 will increase both the volatility and return of the index, due to the higher beta and return of the technology firms, as the market risk becomes more correlated with the technology sector. However, this, by no means, indicates a negative impact on the market, because as markets become more efficient in pricing technology and adjusting to the volatility associated with the new economy, the reward from technology sectors can outweigh the risk from sector-specific volatility. After all, as people continue to demand and consume different types of new technology, the benefit of technology is likely to outweigh its risk to individuals, businesses and financial markets in the foreseeable future.