Today’s Wall Street Journal shows that large-cap technology stocks are priced as if economic and earnings growth will continue for the significant future. However, this late in the cycle, the probability of a hiccup increases, making share prices vulnerable.

The article focusing on tech shares makes for uncomfortable reading even if most of the tech names are profitable, because we are seeing valuation extremes in technology only surpassed by the tech bubble. And that suggests, given the heavy weight of technology shares in major indices, investors leveraged to passive investment strategies are de facto leveraged to tech.

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 Shares in technology companies are outpacing other sectors this year by the widest margin since the height of the dot-com era, with a handful of key players dictating how markets are performing around the world.

Just eight companies—Facebook Inc., Apple Inc., Amazon.com Inc., Netflix Inc., Alphabet Inc., Baidu Inc., Alibaba Group Holding and Tencent Holdings Ltd.—have increased by $1.4 trillion in market cap in 2017, a sum roughly equivalent to the combined annual GDP of Spain and Portugal.

As the tech sector has become bigger and more influential within global stock indexes, its ascent has helped take U.S. and Asian emerging stock markets to record highs—but left behind the less tech-heavy bourses of Europe, Canada and Australia.

“There’s no doubt the markets that have high tech components will have been the best performers this year,” said Paul Markham, a global equities portfolio manager at Newton Investment Management, who has invested in many of the tech behemoths. “The narrow nature of this rally has to be seen as something of a concern…but these are cash-generative companies who are being seen as the bedrock of the new economy.”

I don’t buy this last statement. Yes, most of these companies are generating cash. But not only are the valuation gains are astronomical, you have companies like Netflix and Tesla, which are burning cash and still a part of the tech investment boom. And let’s remember that Amazon, with a market cap over $500 billion, trades at a P/E ratio of almost 300x earnings. A monster portion of Amazon’s capex will have to turn out to be for growth only, and fall to the bottom line once growth slows, to justify that multiple.

As worrying for me is the fact that global tech stocks, with year-to-date gains of 41%, are up 20.5% more than the second best sector in the economy. First, to justify that level of outperformance, you would need to see the sector as a whole have earnings growth that far surpasses even the next best sector for multiple years. Second, 41% growth for an entire sector is an enormous year of growth and clearly not sustainable. And third, market leadership this narrow is the hallmark of a late cycle stock market rally, just as it was during the tech bubble in the late 1990s.

Here are a few tidbits from the Journal article that point to unsustainability:

• “The U.S. tech sector alone now has a combined market capitalization of $5.4 trillion, bigger than the $5.2 trillion in the entire MSCI Emerging Markets index or the roughly $4.8 trillion of its eurozone counterpart.”
• “The Nasdaq has hit 66 record highs this year, while a 32% climb in emerging-market equities has largely come from a handful of dominant tech players and the companies that create hardware for them.”
• “Just four companies—Samsung Electronics, Tencent Holdings, Alibaba Group Holding and Taiwan Semiconductor Manufacturing Co.—now make up a combined 17.4% of the MSCI Emerging Market Index, even more influential than Facebook, Apple, Netflix and Alphabet are within the S&P 500.”
• “For MSCI Europe, roughly 85% of its underperformance relative to world stocks can be attributed to differences in the weight and performance of their technology sectors, according to Morgan Stanley. MSCI Europe has a less than 5% weighting to technology companies, compared with a 24.6% weight in MSCI USA and a 17% weight in MSCI World.”

So what happens if the economy enters a recession in the next five years as is likely?

Let me give you a hypothetical example, using the math for a fictional company Face-Appnet Amazogoog aka FANG. This company has anticipated earnings growth of 20% over the next ten years that yields a 10-year terminal earnings number 6.19x today’s earnings. And since investors are willing to pay 3 times that level of earnings for FANG, the company trades at 18.6x earnings, less than the S&P500, by the way.

Now, in my hypothetical example, in 5 years’ time, FANG has earnings of 2.5x today’s earnings. Let’s imagine that the global economy has a short and shallow recession in that year, 2022. If FANG is a company with high levels of operating leverage such that sales growth of 12% generates revenue growth of 20% due to the scalability of FANG’s platform, we should expect that leverage to work just as acutely in the opposite direction in recession. So let’s dock FANG’s 2023 earnings by 20% as revenues fall 12% that year.

If FANG’s earnings fall 20% in 2023, the revenue multiple for that year falls to 1.99x today’s earnings instead of increasing from 2.49x in 2022 to 2.99x in 2023. That’s an ENORMOUS difference. If you leave everything the same, you get to a terminal earnings value in 10 years of 4.12x. Basically, recession, even five years out, cuts FANG’s terminal multiple by a third.

But if you look at FANG in 2023 with a jaundiced recession-tinged eye, you might pay 2.5x the year 10 multiple instead. So multiple contraction and recession take this stock down, not just 33% but 45%.

How likely is a recession by 2023? How likely is multiple contractions during that recession? What do buy and hold investors do with their portfolios at that time? And what impact does all this have on asset values economy-wide?

My own answers to these questions tell me that the expected return in stocks, given the valuation levels today, is small, if not negative. And when investors understand this, we are going to have a wholesale (and calamitous) readjustment in the market. That’s how stability breeds instability – and why the chances of a significant fall in asset values increase as business cycles lengthen.