In a previous article we argued that the elevated level of stock valuations are not necessarily a problem. The flattened and elongated business cycle and low bond yields offer sufficient explanation for this even if we do have a problem with the quality of earnings.
However, no part of the stock market is valued more exuberantly than the technology sector, and there are specific reasons for this - it's the emergence of platform economics that provides companies with big economies of scale, scope, and network effects which makes their position nearly unassailable.
It is the four horsemen, Microsoft (NASDAQ:MSFT), Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB) and Google (NASDAQ:GOOG) that are the biggest beneficiaries of this platform economics which is powering the markets higher. This often leads to enormous valuation premiums, which actually confer additional benefits to these companies.
For instance, Amazon could simply run a growth business and not worry about earnings as the market would confer it with a stock multiple that other companies can only dream off.
Not only can Amazon issue shares at giant premiums in order to finance whatever it feels like, the investor confidence also largely absolved it from running profits. It hasn't run significant profits until its cloud business took off.
Its ecommerce business can simply run on a break-even basis, giving it a price advantage few competitors can match, as Amazon doesn't have to worry about unhappy shareholders.
Since these platform effects give such powerful increasing returns, these stocks can become terribly expensive but as their positions are near unassailable, this doesn't matter all that much.
This is very nice for investors that worry about high stock valuations as it's driven by tech stocks in general and these platform stocks in particular.
Microsoft is one of these, and it's the oldest platform stock. Its platform originated with Windows, which through a combination of skill and luck (historic errors by the competition), became the dominant operating platform in the PC age.
This produces powerful network effects, as users flock to it because others are using it and it has the most applications, and applications flock to it because it has the most users. Bill Gates became the richest man in the world (he still is, only just), and the rest is history.
Because it's the oldest and most established using economics that is widely understood, and its main platform has actually shrunk for a number of years, its platform doesn't command the super premium valuations compared to the platform stocks mentioned above.
But Windows still is a mighty cash cow for Microsoft, and its relations with the corporate sector has enabled it to embark on a new platform, Azure, Microsoft's cloud business.
Cloud and AI
The cloud business, especially in combination with artificial intelligence, is emerging as the next platform to beat and the four tech stocks are all positioned very well here, which is why we don't expect any imminent substantial correction in their share prices.
AI will cement the advantages because it is based on:
- Big data, sources that are difficult to match for most other companies.
- Self-learning. Machine learning combined with additional data gradually improves.
Of course, the field is open for other companies to develop AI in other fields. We are likely to see a proliferation of these platforms. Microsoft's Azure is of course a sort of platform of platforms as it enables other companies to mount their AI driven platforms.
These increasing return based business models are fantastic for shareholders.
However, the same combination of the accumulation of vast amounts of data and expertise (often aided by AI which tend to increase these advantages) over time rejoices shareholders, it can have negative sides for the economy.
Having private companies sitting on vast data and expertise in particular fields and enjoying difficult to assail market positions might not make them always behave in the best interest of society. Let's give us an example in the case of Microsoft.
The world just experienced the giant ransomware scam called WannaCry, but as a matter of fact, these kinds of digital threats are depressingly common, if not always on this scale.
At the center of this stands Microsoft, as the world's biggest software producer whose vulnerabilities are often at the heart of these cyber attacks.
What is their response? Well, they're calling for a Digital Geneva Convention (from Nakedsecurity):
Cyberattacks by nation states are becoming so unrestrained that civilians urgently need the protection of an internet version of the Geneva Convention, Microsoft's chief legal officer Brad Smith told an audience at this week's RSA conference in San Francisco. According to Smith, the lack of international norms over how nations should behave on the internet was leading the world, little by little, into dangerous territory.
Under such convention, nations would agree to avoid attacking critical infrastructure, or hacking and stealing intellectual property to undermine economies. It would comprise two other elements:
- An industry Tech Accord, creating a shared set of principles and behaviors to protect citizens.
- The creation of a neutral nongovernmental organization which would investigate cyber attacks and attribute these to perpetrators.
Is this a useful idea? Some thoughts:
For starters, it is rather doubtful whether all nations would sign up, or even if that would be the case, whether it would alter their behavior. Would it have prevented the hacking of Sony in 2014 (widely ascribed to North Korea) or the meddling in the US Presidential election (widely ascribed to Russia)? We doubt it.
Another interesting question that bubbles up is whether the US would actually join such a digital Geneva Convention. Multilateral agreements seem to be out of favor in Washington these days, and would the CIA and NSA abide by it?
We're not so sure. After all, it was the NSA which accumulated weaknesses in Windows like EternalBlue, a weakness that is responsible for a host of different infections. It was the NSA hacking tools that were leaked which set the chain of events in motion that led to WannaCry and other infestations.
The vast majority of cyber attacks are run by common criminals, not state actors. A Digital Geneva Convention would do little to stop these.
So while the idea seems lofty, its practical effect is likely to be limited. It therefore smacks more of a public relations effort in order to deflect the responsibility for the vulnerabilities in the software in the first place, which lie with the big software companies like Microsoft, Facebook and Google.
These companies face little in the way of competition, something that doesn't exactly provide the strongest incentives for keeping its software safe.
The problem is, because of the complexity of the software and the cyber attacks, and the fact that the source code of ubiquitous software like Windows is private property, we're ever more dependent on these big companies.
They are the only ones with the knowledge and resources, and with the advent of artificial intelligence in cyber security, which is based on enormous amounts of data, this dependency is only increasing.
So we are sort of moving towards a world where we have a problem, cyber security, but the organizations most likely to be able to deal effectively with the problem are the same ones that bear a good deal of responsibility for the problem in the first place.
It isn't out of the question that if a Digital Geneva Convention would see the light of day, it would turn to the likes of Microsoft for lucrative cyber security contracts, a clear conflict of interest.
Given the advance of artificial intelligence and the few organizations that have the scale, expertise and enormous amount of data required for machine learning, we're becoming ever more dependent upon the few big organizations that have command over these resources.
This is only one example of our increasing dependency on big technology companies.
While the growing dominance of big technology companies like Microsoft, Facebook, Amazon and Google are of course a boon for its investors, but rising concerns about these issues could produce a backlash and increase regulatory scrutiny and burden for them, even if at present the wave seems to go in the opposite direction.
We have seen such movements in the past, at the end of the 19th century where the Robber Baron capitalism led to a wave of regulation and anti-trust laws under Presidents Roosevelt and Taft.
While something similar seems rather unlikely under President Trump, we've seen a decade ago how quickly things can shift in a crisis.
While stock valuations are elevated, especially in the technology sector, the emergence of powerful platforms conferring some companies with near unassailable market positions is one reason behind these valuations.
This holds especially true for some of the biggest market cap stocks in technology, like Microsoft, Google, Facebook and Amazon.
Investors in these names have enjoyed big returns, and there is no compelling reason to assume this can't continue, in the absence of a substantial recession or economic disaster.
However, this upside also has more problematic sides. The concentration of such economic power, data and expertise in private hands might not always best suit the economy at large.
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.