A different tech bubble – powershares qqq trust etf (nasdaq qqq) seeking alpha electricity in india


In a recent article entitled " Netflix and Deal," I illustrated that Netflix ( NFLX), Tesla ( TSLA), and some additional tech heavyweights are among the companies with the highest market capitalizations in the Bloomberg Barclays U.S. Corporate High Yield Index (HYG, JNK). Equity markets are giving these companies large valuations, but rating agencies rate their debt as junk and investors assign meaningful credit risk premia to their bonds. In Tesla’s CDS, I extrapolated this credit default swap premium into a healthy probability of default for the topical Silicon Valley automaker.

I will show that a sector’s debt growth can portend future underperformance of that sector’s bonds and stocks. We will examine three sectors through three unique periods – the dot-com/telecom bubble, the financial crisis, and the commodity crash.

In the lead-up to the bursting of the late 1990s tech bubble, debt growth in TMT (technology, media, and telecommunications) mushroomed. Driven by deregulation after governments opened up markets to new entrants, the telecommunications sector underwent a historic investment spree. That investment was spurred by the rise of new technologies like mobile telephony and internet access that were becoming increasing components of consumers’ lives.

Like we saw in equity markets, which drove tech stocks to soaring heights, this excitement led to increased debt issuance. The graph below shows that from the end of 1997 to the end of 2001, telecom debt in the investment grade corporate bond index (NYSEARCA: LQD) roughly doubled.

With this debt-financed liquidity injection, companies were able to finance large-scale investment projects. These projects notably included the construction of vast fiber optic cable networks. Companies also paid ever-increasing prices for electromagnetic spectrum financed by debt. Rapid debt growth risks mis-investment in projects that do not generate sufficient economic returns to service the debt. Eventually, booms turn to busts – and it was not just higher corporate defaults and widening bond spreads in the TMT space, equities swooned as well.

The graph below shows the iShares U.S. Telecommunications ETF (BATS: IYZ) from its inception in May 2000 to mid-2003. As telecom equities soared, this ETF sought to capitalize on that growth, but instead nearly top-ticked the market, producing -31% annual returns for investors over roughly the next three years. Think of that as roughly 3 consecutive years of 2008-like performance for your portfolio.

When it became clear that the hoopla over the burgeoning telecommunications sector had progressed too far, expectations normalized and investors became much more prudent in financing new projects. Surviving companies in the sector worked to repair their over-levered balance sheets populated by large non-profitable fixed assets. As a result of these dual actions, telecom debt as a percentage of the index began to level off by mid-2003, but the damage had been done.

While the mess from the debt-funded telecom spending spree was getting cleaned up, a new and larger trouble spot was forming. From the end of 2003 to the end of 2007, financials’ percentage of the investment grade bond universe climbed a full 10% – from roughly 35% of the index to 45%. Banks gorged on hundreds of billions of dollars of incremental debt, driven in part by the relaxation of regulation, a redux of the telecom boom/bust cycle.

For a time, financial stocks (NYSEARCA: XLF) tracked the broader market, but that began to diverge in late 2007, as the onset of the subprime crisis made markets realize that once again the debt increase of an industry was used to finance investments that were not going to generate positive economic returns. Financials swooned, highlighted by several of the largest bank failures in U.S. history.

In retrospect, the overleverage of the financial industry seemed obvious. By the end of 2010 – the end of the time horizon above – a new party was already quietly starting. Fueled by rising oil prices and a technological revolution in domestic shale plays, money flowed to the energy sector like a Clampett well. The high-yield bond market was more than welcome to finance the new bonanza. Below I show the independent energy subsector of the U.S. High Yield bond market ( HYG, JNK). The broader energy sector climbed to become roughly 15% of the high-yield market.

By late 2014, the party was over. The U.S. high-yield market largely finances U.S. and Canadian energy plays, given the government intervention in resource plays throughout most of the developing world. As the Saudis chose to no longer limit supply, they forced higher marginal cost production to be shut-in.

As oil prices stayed low, bankruptcies for North American oil companies increased and credit spreads widened. Market access became limited, even for larger, investment-grade companies. We all know what happened to energy stocks (NYSEARCA: XLE). Similar to the previous pain in telecom and financials, energy companies badly underperformed the market.

Over the past fifteen years, we have seen three distinct periods where debt growth presaged equity underperformance. This should be an important indicator for both equity and debt investors. Investors should be asking themselves in which sector have they seen rising debt growth.

I failed to bury the lede at the start of the article – it’s the tech sector. The proportion of technology bonds in the debt-weighted investment grade corporate index increased by more than 3% over the past five years. In a market that is now $5 Trillion, that is $150B of index-eligible incremental debt.

The tech debt growth is unusual. Historically, tech companies have not operated with much debt. Investors participated in tech investments to capture the tremendous upside of transformative technologies, and were less willing to bear the inherent downside of failed investments through debt instruments that offered only return of principal with interest without a share of the potential upside.

As the tech industry has matured, and the leading companies have come to dominate U.S. commerce (and the capitalization-weighted equity indices), they are increasingly operating with higher leverage even as their cash piles soar from retained earnings.

Government tax policy was having a perverted effect on the capital structure decisions of technology companies. Companies with offshore cash did not want to pay the high marginal tax rates to repatriate that money back to the United States. Instead these companies issued debt with their offshore subsidiaries paying a portion of the interest expense on the debt back to the U.S. entity tax free.

The U.S. encouraged its multinationals with large overseas earnings to operate with more debt, and it remains to be seen whether tech companies, which have historically not had levered balance sheets given the dynamism of their competitive markets, will struggle to handle this sharply increased debt load over future periods.

The change in tax policy that effectively ended this debt shell game could arrest this debt build-up before it becomes unsustainable. While debt in the tech sector ( QQQ) has increased, so has earnings and free cash flow. Net leverage in the sector remains fairly low and debt ratings remain high. There are certainly idiosyncratic stories that are worth watching. We saw Dell’s (NYSE: DVMT) MBO and debt-financed acquisition of EMC set records for junk bond issuance in the tech space. The musical chairs M&A dance in the semiconductor space is likely to be debt financed. Netflix and Tesla have tapped speculative grade markets to finance continued negative free cash flow.