Add it to the pile.
US tech stocks have sold off in the past few days. Is this yet another bubble on the cusp of busting?
Thanks to central banks around the world, ‘bubble’ must be the most overused word in finance these days. Everything is in a bubble. It’s just that none of them are really popping.
That’s much to the annoyance of those who yearn for the good old days of friendly valuations and sensible yields.
Ironically though, the good old days of cheap valuations equates to the bad of days of economic turmoil. You can’t have both. If you’re looking forward to the days when stocks become cheap again, you’re looking forward to a pretty bleak future.
So what’s going on with tech stocks?
Well, after rallying strongly so far in 2017, everyone seemingly decided on Friday that enough was enough. It was time to take profits. Let’s check out a chart of the NASDAQ to see what is happening.
As you can see in the chart below, the tech dominated NASDAQ has had a very strong run in 2017. Since April, the ascent accelerated. That was possibly due in part to disappointment over Trump’s plans for tax cuts and infrastructure spending, which sent more capital rushing into the easy gains of tech stocks.
But as often happens in these situations, such easy gains can evaporate within a day. That’s what happened on Friday in the US. Tech stocks plunged, and the selling continued overnight.
How long will it continue?
Well, the index traded down to the 50-day moving average overnight and then bounced. This suggests that automatic ‘buy-the-dip’ orders came in at that technical level.
So you might see a little bounce from here. But the better option (if you’re bullish on tech over the longer term) would be to see stock prices continue to correct lower in the coming weeks or months. That would provide some much needed balance to the market.
Either way, you’re going to hear and read plenty of conjecture about whether this is another bubble bursting or just a ‘healthy correction’.
Keep in mind that the conjecture will largely depend on whether that person is in or out of tech stocks.
Let’s have a look at the main bearish claim about the sector. That is, that it is overvalued. We’ll have a look at the big guns, using the basic price-to-earnings (P/E) ratio as a benchmark.
For reference, according to the Wall Street Journal, the S&P 500 as a whole trades on a P/E of 19 times estimated earnings for the 2017 financial year.
- Alphabet (Google): P/E of 28.6x
- Apple: P/E of 16.7x
- Amazon: P/E of 147x
- Facebook: P/E of 31x
- Netflix: P/E of 151x
Apart from Apple, there is clearly a lot of optimism built into many tech stocks.
Having said that, you can’t just lump all stocks into the ‘tech’ category.
Apple is a consumer goods stock. Its products just happen to be amongst the most sought after in the world. But still, its modest valuation reflects the size of the stock (it has a market cap of $776 billion) and the fact that growth from such a vast size will be necessarily modest.
Google is largely an internet advertising business. It is decimating traditional media companies and growing earnings strongly, so it probably deserves its high valuation.
The really crazy valuations of Netflix and Amazon aren’t as bad as they seem. Both companies are major disruptors of entrenched business models and they are sacrificing short term profits to continue to build their businesses.
As they gain greater and greater scale, the market thinks this will one day translate into big profit gains. The question is, will the profit growth be large enough to justify the current hefty valuations?
Tech stocks should always trade on higher than average multiples. That’s because they represent an opportunity to earn profit growth well above the market average. They’re at the forefront of new industries, creating fast growing markets as well as disrupting old established markets.
Whether tech stocks deserve to trade on their current multiples remains to be seen. But there is little doubt that in the short term they have overshot the mark. I wouldn’t be buying this dip too early. The correction could play out for a while longer.
But I don’t think this is the start of another bubble popping episode.
Because it always comes down to low interest rates. While the Fed is expected to raise interest rates this week for the second time this year, US 10-year treasury yields are still incredibly low.
They’re currently trading at 2.21%, well down from the March high of just over 2.6%.
If you were to put a P/E on 10 year treasury bonds, it would be around 45 times. So compared to the S&P 500 at 19 times, stocks don’t appear to be overly expensive.
Why are bond yields so low?
Well, despite the US unemployment rate hitting 16 year lows recently, this employment growth is not translating into higher inflation — or higher growth levels.
First quarter economic growth in the US came in at just 0.7%. That’s why bond yields remain stubbornly low. And stubbornly low bond yields provide valuation support for stocks.
All the evidence points to a correction, not a crash.