The sell-off in growth tech stocks in just two days has been staggering and it could be the start of diminishing returns over a longer period of time.
The Nasdaq 100 fell 10.2% between Thursday’s open and midday Friday, a textbook correction. The losses, while still severe, moderated later on Friday. Sky-high valuations for Apple (AAPL) - Get Apple Inc. (AAPL) Report, Amazon (AMZN) - Get Amazon.com, Inc. Report, Nvidia (NVDA) - Get NVIDIA Corporation Report, Tesla (TSLA) - Get Tesla Inc Report, Salesforce (CRM) - Get salesforce.com, inc. Report and other large cap growth tech stocks had investors nervous Friday morning, especially as employment data has rolled in showing the continuation of the speedy economic recovery. Jobless claims were lower than estimates, net jobs added for August were higher than estimated and the unemployment rate is now down to 8.4% from 15% just months ago. The unprecedented speed of the drop in unemployment is leading some to favor value stocks like large cap cyclicals over growth. Meanwhile, the Nasdaq 100 had outperformed the S&P 500 in 2020 by a wider margin than what was seen in 2000, just before the tech bubble burst. The index was up 35% for the year into Thursday morning and was still up 25% for the year at the bottom of the correction.
The tech correction could be the beginning of a more secular shift into value stocks from growth for years to come, one strategists argues. For the short-term, investment managers TheStreet spoke with Thursday noted the sell-off could continue for days, as valuations are still high. Tesla, after having sold off more heavily than most big tech stocks Thursday, still traded at a 140 times forward earnings multiple Friday morning that — compared to its expected earnings per share growth rate of 40% over the next few years — leaves the stock looking quite frothy. That’s a PEG ratio — price-to-earnings to earnings growth — of 3.5. A fully valued company can often be roughly 2 times. Some may buy this dip soon, looking for earnings growth to continue carrying these stocks higher, once their valuations ease. And in 2018, FAANG stocks, which now comprise about 25% of the S&P 500’s market capitalization, corrected. That came before investors appreciated the new growth drivers (Facebook’s FB Instagram, Apple’s services, Amazon’s cloud and one-day e-commerce delivery to name a few) of the innovating companies in the group. The group rose furiously in 2019 and for most of 2020. But with every new iteration of earnings growth, with every new leg of stock price outperformance and subsequent correction, these mega-caps likely come closer to their day of reckoning. That’s especially true if history is any guide.
The Beginning of the End?
"The current market level is pivotal: the cyclically adjusted price-to-earnings multiple (CAPE) of the S&P 500 is knocking at the doorstep of the same point at which CAPE broke out in the last two years of the most powerful bull markets of the past century, the late 1920s and late 1990s,” wrote Barry Bannister, head of institutional equity strategy at Stifel wrote in a note. The CAPE ratio adjusts earnings for cyclicality, or the expectation that economic fluctuations will move earnings up and down. “ If CAPE does break out, the building (and inevitable bursting) of a bubble could make the market a “greater fool game” challenge in the near-term and a modest return vehicle longer term, dashing the optimism of investors (as the market often does).” Bannister notes the S&P 500’s potential downside because substantial downside in tech would weigh heavily on the index, but he focuses his research on the specific topic on the Nasdaq 100.
Current tech earnings multiples are near where they were in 2000. Bannister noted this, but there are two important points to consider against that point for now. First, interest rates are far lower nowadays then they were in 2000. This boosts valuations for several reasons, but one major reason in that companies’ free cash flow is discounted at lower rates in a lower interest rate environment. Amazon AMZN, Microsoft (MSFT) - Get Microsoft Corporation (MSFT) Report, Apple, Facebook (FB) - Get Facebook, Inc. Class A Report and Google (GOOGL) - Get Alphabet Inc. Class A Report do not have much debt, so they are less impacted. But investors sometimes feel they have no alternative other than stocks when rates are so low. Tesla has a meaningful chunk of debt. Secondly, many tech companies in 2000 not only had no earnings, but no revenue. Current tech valuations imply based on a steam of long-term premium earnings growth.
Nonetheless, Bannister notes that current valuation levels remind his research team of the growth run-ups in the nifty-fifty in the 1970’s and the tech bubble in 2000. The nifty-fifty, which, featured expanding consumer and manufacturing companies like Coca-Cola (KO) - Get Coca-Cola Company Report and General Electric (GE) - Get General Electric Company (GE) Report, is not completely comparable to big tech now, but they were market leaders for a long time. Bannister said, “for both the 1972 Nifty Fifty and 1999 NASDAQ 100, price-to-earnings compression offset strong EPS the next decade.”
That’s what investors now are afraid of. Many are afraid that accelerated growth rates for at-home services like streaming, enterprise software, new data storage technology and trends are pulling forward substantial amounts of demand from years further out in valuations. Earnings growth is, no doubt, strong for the current behemoths. Nvidia is looking to grow EPS at a compounded annual rate of about 23% for the next few years. For Salesforce, that CAGR is about 25%. It’s above 20% for Amazon. But if investors begin to “re-rate” valuation, the solid one-year earnings growth each year may not be enough to enable these stocks the outperform the broader market anymore.
Bannister said the nifty-fifty, which ran up into the 1970’s, had premium annual EPS growth of 10.2% between 1972 and 1982, compared to the S&P 500’s 7%. But in that time, the earnings multiple on the nifty-fifty fell 9.6%, compared to the S&P 500’s multiple compression of 4.9%. The annualized total return (which includes dividends) for the fifty in this 10-year period was 3.1%, against the S&P 500’s 6.7%.
After tech stocks ran-up into the 2000’s, the Nasdaq 100’s EPS grew at 7.9% annually between 1999 and 2009, better than the S&P 500’s 1.4%. But tech multiples fell 13.5% in that time, against the S&P 500’s valuation compression of 4.1%. The Nasdaq 100’s annualized total return was negative 6.4%, while the S&P’s was just negative 0.9%.
As the economy rebounds aggressively from the pandemic, some many are vigilantly checking inflation (the added money supply has been drastic) and normal economic growth. This could favor cyclical value stocks.
The point: it’s hard to say if we are the end of an era, but for most investors, going all in on big tech is getting riskier.