Since the U.S. stock market started its rebound in early April of this year, technology has been the leading sector. Driven initially by mega-cap tech behemoths Amazon AMZN , Apple AAPL , Facebook, Google GOOGL , Microsoft MSFT , and Apple, the tech rally has spread into some fast growing mid- and small-cap stocks as well as high-profile IPOs like Snowflake.
Many investors and pundits are concerned that tech stocks are experiencing a bubble, as in 1999‒2000. However, instead of excessive optimism about the future, rising tech valuations may reflect pessimism about future economic growth and profit weakness in other sectors. Given the current high unemployment rate of 8.4% and the large number of small business closures, Consumer Cyclical, Basic Material, and Energy stocks could have muted profits for an extended period. Technology’s secular growth, fueled by the Internet, cloud computing, ecommerce, and the ongoing digital transformation of business, is simply more attractive to investors than most other parts of the market.
S&P 500 overall earnings are expected to decline 3% in 2020 when companies with losses are excluded (see table above). However, Wall Street is optimistic for 2021, expecting a 13% bounce in profits. Many of 2020’s worst sectors are expected to have the highest earnings growth next year. Cyclical groups are expected to have the fastest profit growth, led by Energy (+20%), Transportation (+19%), Consumer Cyclical (+19%), and Basic Material (+18%). In contrast, Technology is only expected to grow roughly in line with the overall market at +14%. Given Technology earnings’ modest expectations and comparatively secular nature, the sector is more likely to meet earnings expectations than cyclical sectors with higher expectations.
I believe investors are still cautious or negative on the U.S. economy, so they will pay a premium for Technology stocks because they believe those companies will not disappoint earnings expectations, unlike riskier cyclical groups with high expectations. Investor money has logically flowed into Technology and away from other sectors.
Despite this, Technology’s premium remains far below that of 1999‒2000. Currently, the S&P 500 Technology sector is trading at a premium of approximately 20% to the market or 25x the next twelve months’ earnings, compared with 21x for the total S&P 500. As Bloomberg Intelligence Chief Equity Strategist Gina Martin Adams recently documented, this compares with a 28 P/E multiple point premium on a 50x absolute multiple in 1999‒2000.
Given the positive secular drivers I mentioned, this premium does not strike me as excessive. One reason for this is that business models have changed in the Technology sector and companies have dramatically more stable revenue and earnings streams. This is mainly the result of two factors: first, through products like the smartphone, consumers now constitute a larger portion of tech spending, which is less cyclical than corporate capital expenditures; second, many new business models, particularly Software as a Service and digital media/Internet, have a higher portion of recurring revenue than companies in the 1999‒2000 bubble, which emphasized quarterly corporate spending.
Investors’ drive to find growth has led them into the IPO market. 2020 IPOs are currently performing far better than stocks that went public in 2016‒2019. But, if we are currently in a second technology bubble, it is surprising that tech IPOs have not done even better. Twenty-four 2020 Technology IPOs are up an average of 40% from their issue price, just slightly better than this year’s average of 35% across all 133 IPOs. One significant factor is Health Care’s SBRA dominance this year, with 66 IPOs up an average of 48%.
It’s also important to note that the overall market and economic environment is the opposite of what it was during the last tech bubble. In the late 1990s, the U.S. economy was growing strongly, the stock market was booming, interest rates were rising, and the Fed was tightening. Today the U.S. economy is, hopefully, emerging from the recession caused by COVID-19, the Fed has lowered rates to historic levels and is seeking to boost money supply growth, and in March the market experienced one of its worst drawdowns ever.
Despite the recent volatility, there are still stocks I would buy today, favoring growth but also looking for relative strength leaders during pullbacks, as these stocks have a strong tendency to continue outperforming once the market stabilizes.
Three attractive names right now are semiconductor design company Marvell Technology MRVL (MRVL), which is tied to growing 5G and datacenter end-markets as well as potentially recovering automotive; Pinterest (PINS), whose interest discovery platform has a high degree of potential monetization; and ServiceNow NOW (NOW), who provides workflow and IT automation software with nearly 1,000 corporate contracts of annual value greater than $1M.
If we are in a technology bubble, the premium being afforded the sector is mild relative to that of past bubbles. If the market pulls back before the presidential election, as I examined in my article last month, I would view it as a buying opportunity for high-quality Technology stocks. Along with prescription drugs, biotechnology, and medical devices, Technology continues to be at the forefront of innovation in this country, and I believe it will remain one of the market’s and the economy’s leaders.
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