Introduction

Growth stocks and notably FAANG stocks, which include Facebook (FB), Apple (NASDAQ:AAPL), Amazon (AMZN), Netflix (NFLX) and Google (GOOG) (NASDAQ:GOOGL), have been leading the markets higher for the past three years at least. These FAANG stocks are responsible for most of the market gains including the Nasdaq (QQQ) and the S&P 500 index (SPY). So far in 2020, their performance has been phenomenal, and investors keep piling up on these few tech stocks. If you were invested in anything else than FAANG stocks, most likely your gains would have been much less than the S&P 500 index.

There’s no doubt that COVID-19 has changed many aspects of our lives, and many technology stocks will see increased business. So the rally we have seen has many merits. Further gains are probable. We also have been reading that these tech stocks have become expensive. While these valuations are true in absolute terms, if you compare the valuations relative to Treasury yields, they are not that expensive. In this article I will address what would cause this tech rally to stop and will eventually cause a bubble burst.

The Case for Growth Stock

By definition, growth stocks are stocks that are able to deliver capital gains growth to shareholders, or the potential for strong growth. The bull rally relies on two main things:

  1. Strong economic growth to achieve continued exponential growth, or potential exponential growth in earnings.
  2. Valuations to be reasonable that would allow this bull market to continue.

We make the case in this report that neither of these two factors will be available in the near future that would allow these stocks to continue to go higher. Again, don’t get me wrong, the short term still looks promising, but the medium and longer term for these stocks looks very grim.

Longer-Term Headwinds: Economic Growth

As stated above, growth stocks rely on mostly economic growth to boost their income. Economic growth is directly linked to both population growth and increased efficiency/productivity. However, economic growth is the key here, and is directly linked to population growth. It’s very important to note that population growth across the globe has been stalling. Today is very different from the 1950s, 1960s, 1970s and even in the 1980s. Back then, corporations were able to rely on population growth in order to achieve much of their earnings growth without much effort.

Let us have a look at population growth historically and today. There’s a countervailing trend, mostly impacting the developed world, where fertility rates are falling with couples having fewer children. This is bringing rapid population growth to an end in many countries already, and will soon be globally also.

The global population growth rate already has slowed down considerably: It reached its peak at over 2% in the late 1960s and has been falling since then.

Although the rate of growth is slowing, the UN is projecting that the global population will increase from 7.7 billion in 2019 to 11.2 billion by the end of the century. By that time (in the year 2100), the UN projects, global population growth will come to an end, and will be near zero.

Source: OurWorldinData.org

As we can see from the chart above, from now until the year 2100, the rate of growth in world population will be on a continuous decline. Further bad news is that the population growth declines is mostly coming from the developed world such North America, Europe, and Japan. In fact, population growth in the United States is even more alarming. Historically, the U.S. population growth rate was between 1% to above 1.5% per year until the year 2000 as we can see in the chart below:

The U.S. census projects a regressing annual growth rate, starting at 0.8% in 2015 and decreasing to 0.46% percent by 2060. This is a significant decrease in growth.

The developed nations will be more impacted than others, and thus will have a big impact on companies that rely on demographic growth. We can take a look at Italy, Germany, Japan, Greece, and many others where the workforce has been considerably shrinking and severely slowing down their respective GDPs.

How Does Population Growth Impact Economic Growth?

Let us have a look at the baby boom generation. Once this generation grew up in age, moving from the dependency stage to the productive phase (or joining the workforce), standards of living across America vastly improved. That’s because this large generation of Americans became big consumers of goods and services. They also need homes and cars. This drives demand up, and also corporate profits.

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On the other side, aging or declining populations in countries like Japan and Italy means that a smaller cohort of working age people will be called upon to support growing numbers of retirees, slowing economic growth. Furthermore, having less people joining the workforce means that there’s less productivity and spending power. Germany just reported that it saw its population shrink for the first time in a decade, with the number falling by 40,000 in the first six months of this year to 83.1m. Germany has long been struggling with a Japanese-style combination of low birth rates, an aging society, and a stagnant population of working-age people. Economists are concerned that these factors negatively impact productivity, growth and public finances. These are very serious issues being faced today by several developed economies, and could very well hit the United States in a few years.

Companies operating in these countries are likely to see lower sales and lower income growth. For example when the working force shrinks, the demand for items such as PCs, iPhones, Amazon purchases, and home purchases are likely to fall. A declining population will definitely impact these purchases. Let us look at the chart below depicting the US GDP growth in the past 60 years (until the year 2019 before COVID-19 crisis).

Source: MacroTrends

By looking at the chart above, we can see that US GDP was peaking at 6% and 7% back in the 1960s until the 1980s. However since the year 2006, GDP growth has barely peaked above 3%. As argued in this report, the lower GDP growth has a lot to do with population growth in the United States.

This brings us to the conclusion that it’s more and more difficult for corporations such as the FAANG companies to rely on population growth as they did in the past. In fact, each year that goes by, their growth potential is diminished as the “wealthier” developed world sees less growth in people joining the workforce.

Population growth is a longer-term headwind for technology stocks. However, there are more dangers in the medium term that investors should be aware of.

Medium Term Risk: Reasonable Valuations

Today, FAANG stocks trade at +30 and +40 times their respective price/earnings ratios (or P/E ratios). The last time earnings ratios for technology stocks were becoming this high was during the dot.com bubble that burst in the year 2000. This was a very painful period, and since then, I’m currently avoiding any company that’s trading above a P/E ratio of 15 times.

Many would argue that today an investor has to look at valuations from a different angle, which is the state of interest rates. Back in the year 2000, interest rates were near 6%. Today interest rates are near zero as we can see from the chart below depicting the 10-year Treasury yield rates.

Source: Trading Economics and Author

Of course, it’s a strong argument that the vast majority of equities are not overvalued today given that even the yields of the S&P 500 companies (which are the most richly valued) are in excess of the 10-year Treasury yields. With most dividend stocks having barely participated in the last few years’ rally, their valuation is arguably extremely cheap. In fact, valuations based on interest rates is probably one of the most reliable ways to value stocks.

Even if we look at the FAANG stocks, relative to interest rates, they are also not grossly expensive. However, will interest rates remain low forever? This is a very important question because the state of interest rates can greatly impact valuations, and what may not look overvalued today could suddenly become a “bubble stock.”

The State of Interest Rates

Interest rates and fiscal stimulus are two great tools that central bankers across the globe use to help stimulate the economy. This is especially true in the United States where the Federal Reserve has been using them for decades to control the U.S. economy. During periods where the economy is in trouble, the Fed lowers interest rates, and uses fiscal stimulus to help boost the economy. On the other hand, the Fed raises interest rates when the economy is heating up, and inflation kicks in.

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Today, it looks like the U.S. Fed already has used the full extent of its interest rate stimulus policy because interest rates are near zero. This creates a significant problem. What would happen if the recession continues? The only way to use the “lower interest rate” tool is by reducing them to a negative rate, similar to what Europe has done. However this is a very tricky situation. Negative interest rates are very harmful to the economy for two main reasons:

  1. Negative rates weakens commercial banks because it becomes very difficult to generate interest rate spreads to make profits. We know that having a strong banking sector that can finance the economy is a must. Weak financial institutions by itself could negatively impact the economy.
  2. Even a more serious situation arises. Negative interest rates will eat up the savings of retirees and the rest of the population, and impoverish a large group of our society.

Therefore, the Fed has to tread very carefully here, and there is no win-win situation. Someone will have to get hurt by negative interest rates.

What Lies Ahead?

The situation in the United States is much better today than the situation in Japan and Germany. It will take some years to reach the same problems that these two countries are facing with a population decrease. Still, investors should be aware that if the financial impact of COVID-19 lingers, or if we hit another recession in a few years, the Fed has less ammunition to work with, and may need to face negative interest rates. There’s not a lot of room to go lower, there’s a practical limit of going into negative territory.

Impact of Printing Money: Someone Will Have to Foot the Bill

Even if we have an economic recovery soon, we need to keep in mind that all the money printing and excess liquidity that have ballooned our financial deficit comes at a cost. Here is what’s likely to happen going forward:

As the economy recovers, there will still to be ongoing additional fiscal stimulus and money printing. The world (and the United States) today are awash with liquidity due to all the monetary easing that has taken place in the past year due to COVID-19. Central bankers across the globe have printed the equivalent of trillions of dollars while consumers had reduced spending due to the pandemic. The money printing has ballooned the U.S. national debt significantly as we can see from the chart below (figures in trillion U.S. dollars):

Source: Trading Economics

The public debt is now over $27 trillion:

Source: Peterson Foundation

Large banks have reported huge increases in their deposits, including some reporting a 20% to 30% increase since the outbreak of the virus.

Source: StLouisFed

In fact, banks are swimming in customer deposits which have reached $16 trillion with a huge spike since March 2020. This is because consumers were spending less money during the outbreak and receiving stimulus checks at the same time. Furthermore, due to economic uncertainties, consumers are being more careful with money.

The debt in itself is not the problem since the U.S. government can continue printing dollars to pay out debt. However printing money and excess liquidity is the main problem. The bank deposit boom is just one sign of this excess liquidity. It remains to be seen what the ultimate consequences are for the government’s historic spending binge.

The likely result? This excess liquidity and large deficit comes at a cost, and someone will have to pay. As the economy recovers, we will see a steepening yield curve, which will push both interest rates and inflation higher. The excess liquidity created in the system will most likely result in inflation, higher taxes, and the collapse of the U.S dollar.

Inflation is an indirect taxation that all of us have to pay as a result of the excess cash in the system. Coupled with low growth, the bill will be a hefty one to pay up.

Using Interest Rates and Tech Stock Valuations

Today, we are likely to remain in a low growth environment for a couple of years. The Fed will to continue to use fiscal stimulus including printing money. Interest rates and inflation will start edging higher. This will take a couple of years to materialize because most of this excess liquidity is expected to remain in the financial system, keeping downward pressure on rates. In the meantime, there could be more upside potential for growth stocks.

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However as interest rates rise which I expect in late 2022 or 2023, all of a sudden the red-hot tech stocks will have very expensive valuations relative to interest rates. There’s no reason for growth stocks such as Google and Apple to trade with P/Es of +40 times other than a low interest rate environment which helped them boost both profits and valuations. Such high P/E ratios, coupled with higher interest rates results, will push their valuations into a excessive levels. In fact, I would argue that we would be heading into another tech bubble burst in a couple of years. Personally I’m avoiding (and recommending to avoid) red-hot tech stocks. There’s just too much risk involved if interest rates go up unexpectedly.

The state of interest rates is the biggest risk to tech stocks today.

Best Course of Action For Investors

While the bull market for technology is probably not over yet, there are clear medium-term and longer-term dangers. Higher interest rates will result in excessive valuations for this sector, even if prices do not go much higher. A tech bubble burst in late 2022 or in 2023 is very possible.

The best options available for investors today are “value stocks” that have vastly under-performed growth stocks, and many of which are trading at decade low valuations. Historically, value stocks tend to outperform growth stocks during the initial stages of rising interest rates. Furthermore, value stocks in general have little downside risk, but plenty of upside to catch up to due several years of under-performance.

Importantly, investors should be planning ahead to hedge their portfolio from now against rising interest rates, and there are many options to do so. Some examples are commodity producer stocks, or the commodities themselves, which can be a good inflation hedge. Other options are available with TIPS and variable rate loans. TIPS are currently yielding negative rates, but as inflation kicks in, yield and prices are set to soar.

Some other great options for income investors include fixed-to-floating preferred stocks, variable-rate fixed income CEFs, and property REITs. We are bullish on property REITs because real estate is one of the better options to hedge against inflation.

At High Dividend Opportunities we are currently targeting high-dividend stocks trading at low valuations, or value dividend stocks. You want to buy stocks when their yields are high relative to their norms. To put it simply, you want to buy this stock when “dividend per dollar” is high. This means the price is low. In general, the higher the dividend yields produced by investments, the less they will be impacted by rising interest rates. We currently are overweight property REITs, especially those that provide a good inflation hedge. We also are starting to build floating rate high-yield products and defensive stocks within our Model Portfolio. Taking an early proactive stance is key to successful investing. You always want to be ahead of the game. We plan to get more aggressive in inflation hedges as we head into the years 2022 and 2023.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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