Stock market risks associated with the largest tech companies by Aleksei Kirilov & Valeriy Kirilov

The almost non-stop growth of the stock market over the past year and a half from April 2020 to November 2021 (at the time of this writing) has far outstripped the economic recovery. What was the main driver of this growth, how long will it last, and what potential threats can it create? To find answers to these questions, we analyzed the behavior of one market sector - the largest technology companies. Information from Yahoo services https://finance.yahoo.com and Finviz https://finviz.com was used as the initial data.

the role of tech companies

Figure 1 shows graphs of the relative change in the S&P 500 and Russell 2000 over two and a half years from mid-May 2019 to mid-November 2021.

As shown in Figure 1, starting in early 2021, Russell 2000’s mid-cap and small-cap stocks have stalled, unlike the S&P 500 stocks.

Figure 1 Figure 2

In order to analyze how the shares of the largest companies changed from mid-May 2019 to mid-November 2021, we took the seven largest companies with a capitalization of more than $ 500 billion, with the exception of Tesla: AAPL, MSFT, GOOG, GOOGL, AMZN, FB, NVDA1 .

The next descending capitalizations of BRK-B and BRK-A (Berkshire Hathaway Inc.) are rather funds. And the next in terms of capitalization, JPMorgan Chase & Co. is already far behind NVDA, see Figure 2. For brevity, in what follows, we will refer to the listed seven companies as FAMANG. Unlike the well-known abbreviation FAANG, Microsoft has been added here and, in addition, Netflix has been replaced by NVIDIA.

1 / Tesla was excluded from this list because, in our opinion, the change in the stock quotes of this company deserves a separate study and is beyond the scope of this article.

Next, we compared the change in the S&P 500 index with the shares of FAMANG companies from midMay 2019 to mid-November 2021. The results are shown in Figure 3. It can be seen that, during the period under review, the companies of the FAMANG group grew much faster than the S&P 500 and Russell 2000. The dynamic of changes in the total capitalization of the FAMANG group of companies in comparison with the dynamics of the S&P 500 and Russell 2000 indices is shown in Figure 4. Figure 3 Figure 4

Then, we examined how the weight of the total capitalization of FAMANG companies has changed in comparison with the capitalization of the entire market, which is depicted in Figure 5. The weight of the seven companies of the FAMANG group in the capitalization of the entire market in the period under review increased by 7% and, as of November 17, 2021 was 22.2%. A natural question arises, to what extent was the growth of the entire market provided by the growth of these seven companies? In search of an answer, we built a linear regression of the dependence of the S&P 500 change on the FAMANG capitalization change according to the data in the period under review. The equation is shown below.

Regression equation: S&P 500=1494.76 + 0.0002542 × FAMANG, R2=0.92

The t-statistics for the coefficients are 61 and 86, respectively, which is much higher than the critical value of 2.58. Therefore, the obtained values of the coefficients are significant. The F statistic is 7,425, well above the critical value of 6.67. Therefore, the obtained regression equation is significant.The coefficient of determination R2 is 0.92, that is, 92% of the change in the S&P 500 variance is explained by the change in the capitalization of FAMANG companies.

Figure 5 Figure 6

The results obtained suggest that the growth of the S&P 500 in the period under review was largely fuelled by the growth of the largest technology companies and, above all, by the growth of the seven FAMANG companies.

tech companies’ high sensitivity to interest rates

conclusion

Probably in the future this could potentially lead to significant risk for the stock market as a whole. This is because all seven companies in the FAMANG group are strong growth companies. These companies are characterized by a high sensitivity to the interest rate at which investors discount their future earnings. In the face of strong inflation this year, the Fed was forced to decide to roll back its quantitative easing program, starting in November. In one of our previous articles, we wrote that the delay in the Fed’s decision to tighten monetary policy will lead to a surge in inflation in the fall and possible subsequent problems for the stock market2. Today it is already clear that in 2022 the Fed will be forced to raise interest rates.

In order to gauge this sensitivity, we tried to at least roughly estimate the degree of influence of an increase in interest rates on the stock market based on the available data. There were two short periods in 2021 when the yield on 10-year Treasury bonds increased monotonically: from about February 5th to March 18th and from September 14th to October 8th. In the first case, the yield increased by 0.56%, in the second by 0.29%. In the first case, the sensitivity of FAMANG’s capitalization to changes in the interest rate amounted to -1.16 trillion dollars with an increase in yield by 1%. In the second case, -2.39 trillion dollars with an increase in yield by 1%.

Inserting these results into the above regression equation, we find that for a 1% rise in interest rates, the S&P 500 could decline 6% - 12%. Of course, the result obtained is just a rough estimate that does not take into account non-linear effects, reduced liquidity, cross-border capital flows and many other effects. It is worth recalling here another factor that may accelerate the market’s decline in such a situation. According to FINRA data, brokers’ margin debt has grown strongly this year and reached $936 billion in October, which is an all-time high3. Therefore, a strong market drop will cause a large number of margin calls, leading to a further decline in stocks.

So, until recently, the heavily overvalued major tech companies have been the main driver of stock market growth. After the end of the quantitative easing program, in the face of insufficient liquidity and rising interest rates, a sharp decline in technology stocks could cause a serious collapse of the entire market. Thus, in the coming months, the largest technology companies, instead of a growth driver, may become a serious threat to the stock market.

2 / F Aleksei Kirilov, Valeriy Kirilov. U.S. Economic Recovery Mirrored in the Stock Market. Intelligent Risk (PRMIA), July 2021, https://issuu.com/prmia/docs/intelligent_risk-july_2021-issuu

3 / https://wolfstreet.com/2021/11/18/stock-market-leverage-spikes-margin-debt-up-42-yoy-fed-warns-about-high-leverage-ratio-of-younger-retail-investors/

Perhaps the safest scenario in the current situation would be a significant but gradual decline in the stock market. To this end, at its next meeting the Fed would be well-advised to decide on plans for a sharper reduction in the quantitative easing program under the pretext of fighting accelerating inflation. In the future, the Fed’s leadership should regularly make hawkish statements regarding monetary policy. These pronouncements would be a good incentive for investors to cut their long positions in technology stocks, especially the shares of the most overvalued companies, which include the companies of the FAMANG group. That would allow the Fed to implement a strategy of “controlled” reduction of stock prices of the largest technology companies.

authors

Aleksei Kirilov

Partner, Conflate LLC

Conflate is a Russian management consulting company specialized in strategy, risk management, asset management and venture investment. As the partner of Conflate, Aleksei is responsible for asset management and venture investment. He specializes in the US stock and debt markets. Aleksei has more than 15 years of experience in financial services including development of financial strategy and financial KPI, liquidity management; controlling system, allocation of expense on business unit, financial modeling and debt finance. He has cross industries experience: banks, oil & gas manufacturing, real estate.

Aleksei has an MBA from Duke University (Fuqua School of Business), a financial degree from Russian Plekhanov Economic Academy and an engineering degree from Moscow Engineering Physics Institute.

Valeriy is the General Manager at Conflate LLC. He has 15+ years’ experience in risk management and management consulting (BDO, Technoserv, then at Conflate). Besides he previously worked in the nuclear power industry (safety of Nuclear Power Plants).

Valeriy has an MBA from London Metropolitan University as well as a financial degree from Moscow International Higher Business School MIRBIS and an engineering degree from Moscow Engineering Physics Institute. He holds the PRM and FRM certifications and the certificate of Federal Commission for Securities Market of series 1.0. Valeriy was a member of the Supervisory board of the Russian Risk Management Society in 2009 – 2010.

Valeriy Kirilov

General Manager at Conflate LLC