How Apple and Microsoft could blow up the stock market

Is there a bubble brewing in big tech stocks?

Microsoft, Apple, Amazon, Google owner Alphabet and Facebook are the largest companies in America, with a collective market value of $4.5 trillion.

That means that popular passive index ETFs like the SPDR S&P 500 and Invesco QQQ Trust, which tracks the Nasdaq-100, skew disproportionately towards the tech sector.

To put into context just how gigantic these titans of tech are, consider this: Microsoft and Apple, now worth about $2.1 trillion combined, equal nearly the entire $2.2 trillion market cap of all the companies in the Russell 2000 small cap index, noted Chuck Royce, chairman and portfolio manager for small cap investing firm The Royce Funds, on a recent Royce Funds video.

Royce said that the biggest companies in the S&P 500 normally have a collective market value that’s worth about 50% of the Russell 2000.

“The mega-caps are sort of what everyone has come to think of as the most important enterprises around the world. They are very dominant, very important. They’re very disruptive. So for good reason they’ve achieved a global status. But I think they’re in a kind of bubble as to their specific stock market performance,” Royce said.

So what would happen to the broader market if investors soured on any — or all — of these tech stocks? That would be a big problem.

The bigger they are the harder they fall?

“I don’t think you can ignore the fact that the market has skewed so much towards tech. Amazon and other big techs do benefit from so much money flowing to passive ETFs,” said Adam Phillips, director of portfolio strategy at EP Wealth Advisors. “If there is a sudden stock sell-off, then big techs have more risk.”

Mark Hackett, chief of investment research at Nationwide, agrees.

“The market today reminds me of the late 1990s,” Hackett said, referring to the dot-com bubble, when even unprofitable internet companies were soaring. And stronger companies had price-to-earnings ratios that were likewise astronomical. In March 2000, Cisco had a P/E of 150 and Qualcomm’s was just under 170.

That didn’t end well. For those with short memories, by the end of April 2000 the Nasdaq had lost almost a trillion dollars worth of stock value when the dot.com bubble burst.

“Every time there is a crash, the sectors that flew the highest then fell the hardest,” said Lindsey Bell, chief investment strategist with Ally Invest.

There’s another problem today. In addition to giant tech companies dominating the big indexes, the top market performers this year are mainly tech stocks, too.

Chip equipment company Lam Research has nearly doubled this year, making it the top performer in the S&P 500. The second and third best S&P 500 stocks are its rival KLA and semiconductor maker AMD, both up more than 80%.

With so many big tech companies trading in such rarefied air, it may be tougher for them to generate strong enough earnings gains next year to keep the current rally going.

Investors are usually looking ahead — not in the rear view mirror. What a stock is worth today is largely a bet on what investors think will happen with sales and profits in the future.

Crit Thomas, global market strategist of Touchstone Investments, thinks earnings estimates for big tech and the broader market are currently too high.

“We’re not really seeing analysts bringing down 2020 earnings forecasts yet,” Thomas said. “We’re not expecting Armageddon or for the numbers to be negative. But 10% earnings growth expectations may be too much.”

Techs have soared because they deserved to do so

Still, it’s hard to overlook the tech’s momentum. Facebook and Apple both reported strong earnings this week. Microsoft continues to gain ground in the lucrative cloud computing business.

Even Netflix, which has been hit by concerns about increased competition in streaming from the likes of Amazon, Apple and Disney, has enjoyed a nice pop lately after the company reported better-than-expected subscriber gains for the third quarter.

“Investors have been focused on tech for good reasons. It’s very hard to dismiss a sector like tech because of what it’s done for the market for the past few years,” said Yousef Abbasi, director of US institutional equities and global market strategist with INTL FCStone.

If investors start to question the growth prospects of tech companies, Abbasi added, they may simply shift more money into other more traditional value-oriented sectors like energy, health care, industrials and financials.

In other words, a tech sell-off wouldn’t necessarily lead to a massive market slide because other stocks would pick up the slack.

“Tech could underperform but the broader market would still hold up,” Abbasi said.