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Are We in a Tech Bubble Again?

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Tech stocks may just be in a bubble, although it’s truly not so plain to see when one looks under the hood. 

The Nasdaq 100 is up 26% year-to-date, while the S&P 500 is up 4.5% for the year. The Nasdaq 100 encapsulates 100 fairly large growth companies, most of which are in the broader technology sector. The top 10 holdings, which comprise roughly 60% of the entire index, are all of the FAANG stocks, Microsoft  (MSFT) , growth chip maker Nvidia  (NVDA) , Tesla  (TSLA) , PayPal  (PYPL)  and Adobe  (ADBE)

Investors have been willing to pay an increasingly higher price for these stocks. Pre-virus 2020, it had already become clear for some time that the FAANG stocks continue innovating and finding new platforms and avenues for monetization, while the 5G smartphone cycle supports Apple’s AAPL more near-term outlook. Software giant Microsoft is a market leader in the still-growing cloud business. These companies continue putting earnings estimates to shame, while the promising longer-term outlook boosts valuation multiples. Nvidia derives a solid chunk of its revenue from data centers, which power the cloud. 

And then the pandemic hit. These stocks provided shelter from lockdown-sensitive stocks like restaurants and airlines. But as historical levels of unemployment entered the fray, these stocks also provided shelter from cyclical stocks like broader consumer discretionary, oil, banking and manufacturing. Yes, the advertising business is impacted by fluctuations in projected consumer spend because brands spend less on marketing, a negative for Facebook  (FB)  and Google  (GOOGL) . But growth tech stocks provide shelter on two levels. First off, adoption of broader secular trends like the shift in ad spend to digital from traditional media can sometimes power through cyclical headwinds. One analyst pointed that dynamic out as an advantage for Facebook investors after the company’s second quarter blow-out earnings results. The second layer of cyclical protection is that some of the secular themes in tech are void of cyclicality altogether. Cloud spending and internet streaming are mostly recession resistant. And of course, the at-home environment has accelerated some of these growth trends, as seen by Amazon’s  (AMZN)  recent e-commerce results. That acceleration is part of the second layer of cyclical protection. 

Now, the market may be at a crossroad. 

While the outlook may be bright for many of these dominant growth companies, it’s never prudent for an investor to pay any price for an asset just because it will produce some amount in cash flow. These stocks have had an eye-popping run of late. 

The Nasdaq 100 is outperforming the S&P 500 to the same degree it did before the dot-com bubble burst. Barry Bannister, Stifel’s Head of Institutional Equity Strategy, showed a graph in a recent note expressing as much. The graph shows a Nasdaq 100 score relative to the S&P 500 of almost 3.5, with a higher score pointing to a higher level of relative outperformance. The lowest score is 0.75, while the highest on the graph is 3.75. In 1999, before the internet bubble popped, the score was roughly 3.3. For most of the economic expansion from the early 2000’s to the financial crisis, the score sat at around 1.25. The score steadily rose from around 1.3 in nearly 2009, just after the financial crisis, to where it is now. 

The market is currently experiencing "a boom/bubble for long duration, high price-to-earnings growth stocks,” Bannister wrote. “

His statistics show that Apple  (AAPL) , Amazon, Microsoft, Facebook, Google and Netflix  (NFLX)  have contributed to about 7%, 4%, 3%, 2.5% and 2% of the S&P 500’s 50% gain since March 23. Meanwhile, the average contribution from all the stocks in the index is roughly 0.1%. So not only has the Nasdaq 100 far outperformed the aggregate gain on S&P 500, but it has likely outperformed the gain from value stocks in the index by an even wider margin. 

And the market may have already begun to appreciate Banister’s viewpoint, although that appreciation has only been true for an incredibly short period of time. Just in the week of August 10, the Vanguard S&P 500 Value etf  (VOOV) , weighed down somewhat by its low volatility defensive stocks, was up 1.8% by 2:45 EDT Tuesday while its growth counterpart  (VOOG)  was down by about 0.4% and the NYSE FANG Index was down 1.5%. 

But there’s a silver lining. 

In the early 2000’s, many of the soaring and newly public growth tech companies were unprofitable and had zero revenues. Of course, the question always centers around when there will be revenue and profits, but many of those companies were far from becoming money-making entities. The companies in the Nasdaq 100 are largely revenue and profit generating (and growing) entities, with the exception of a few. 

And using those earnings, we can discern that valuations are certainly high for many growth tech companies now, but they are not necessarily unjustified. Amazon is trading at 71 times next 12 month’s projected earnings per share on a GAAP basis, according to FactSet data. That may seem lofty for a company already worth above $1 trillion, but it’s expected to compound EPS at a 38% rate annually for the next four years, making its valuation look somewhat reasonable. 

Apple, which has traded at an average forward earnings multiple of 15 times in the past 5 years, is now trading at 28 times earnings. But that’s because the 5G hardware cycle is expected to boost iPhone shipments for the next few years and COVID has accelerated its already promising and higher-margin services business, which is now expected to grow at above 20% a year for the next several years. Apple’s has a projected EPS compound annual growth rate for the next 4 years of 10%, making it, yes, somewhat unattractive. 

Nvidia often trades at 30 times earnings, but recently it is trading at around 50 times and has an expected EPS CAGR for the next 4 years of 26%. 

That’s a bull’s argument. 

But "Price and fundamentals are separate issues, so despite tech fundamentals perceived now as stronger than the late-1990s bubble, the price pattern is exactly the same: an “ascending curve,” with all the attendant risk-or-reward,” Bannister said. 

It’s important to remember, macro strategists often forecast the market by using statistics, probabilities and historical patterns. What’s irrefutable is that these growth stocks trade at valuations appropriate for their earnings expectations. One question to consider on the earnings estimates: is COVID-related growth sustainable, or is it a mere pull-forward of adoption of these tech services? 

The point: if growth tech is actually a good buy, just expect some near-term choppiness. 

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