Calling a market top has wrongfooted pundits through the ages, but this week's first correction in large US tech stocks since March has stirred the debate again.
Given the outsized influence that tech names and other growth stocks hold over the S&P 500 blue-chip index, their performance from here matters greatly for the broader equity market and for any investors tracking Wall Street with exchange-traded funds.
Recent buyers of big tech stocks, alongside retail punters and institutions involved in speculative equity call option activity, are enduring the most heat at the moment. The tech-heavy Nasdaq 100 index has taken a hit and measures of market volatility remain elevated. A further shake-out of option trades means stocks are likely to remain choppy. To add to the mix, US presidential and congressional elections are just weeks away.
So far this has not rattled broader investor sentiment too badly. Fund managers largely agree that the market had been in need of a "healthy correction" to blow some of the froth off Big Tech and provide a fresh buying opportunity at more attractive prices.
This attitude also reflects a level of comfort among tech investors. A buyer of the March low in the Nasdaq 100 — a bet which appears to have been led by hedge funds at the expense of other traditional managers — holds a gain of nearly 60 per cent, even after the latest bout of selling. Investment portfolios that have ridden the tech and growth stock juggernaut for much of the past decade, and particularly from early 2016, have a far bigger cushion to soften short-term blows.
One big problem for those keen to bet on a bigger tech correction: what is the alternative? Tech still offers solid growth prospects and the potential for a significant return on equity. It still looks good for a while yet, reflecting the acceleration of digital trends for business, education and households in the wake of the pandemic. The premium for owning best-in-class stocks is arguably justified, given a business cycle supported by low interest rates and modest inflation pressure over the next few years.
Even in the event of a vaccine for Covid-19 arriving, shifts in behaviour inspired by the pandemic will keep rewarding innovation and disruption — qualities that define tech companies.
Still, elevated valuations require vindication in the form of robust earnings growth over the coming quarters.
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Before the latest wave of selling, the tech herd had effortlessly propelled price-to-earnings multiples — a common valuation measure — for equity leaders and the Nasdaq 100 into the danger zone associated with the dotcom bubble. For example, the US equity team at Citigroup calculates that once lower corporate tax rates are factored into valuations, the top 10 US tech companies are trading at a trailing 12-month price-to-earnings ratio of 75 times, almost precisely in line with the turn of the century.
It is natural, therefore, to draw comparisons with the crashes that followed other market peaks, particularly those of 2000 and 2007. But those market heights were followed by a protracted decline in earnings growth over ensuing quarters, whereas the hit from the pandemic appears less extensive. Wall Street analysts expect a recovery during the second half of 2020 that gains momentum into 2021.
The safest bet, perhaps, is for a middling performance from here. Aside from valuation concerns, certain tech names with strong business models may have to contend with a stronger antitrust regulatory line from governments in the coming months. The prospect of higher corporate taxes and even levies on windfall profits is serious.
But here is what keeps Wall Street bulls going: "Unless earnings decline noticeably and prove high valuations wrong, stocks do not drop in any persistent way," observes Nicholas Colas, co-founder of DataTrek.
And of course, the interest-rate environment of 2020 is unprecedented. True, the Nasdaq 100 trades around a hefty 40 times earnings for the next 12 months, according to the CME Group. But turn that PE ratio upside down to get the earnings yield for these stocks, at 2.5 per cent. Unlike 2000, this proxy measure of returns sits well above the current 1.4 per cent on offer from the 30-year Treasury bond.
That makes it hard to call time on big tech and the equity growth bull run. A meaningful decline would require a profound shift in well-established economic and financial trends. It would also require a break in monetary policy that few consider to be realistic. Ultimately, other sectors of the stock market will play catch-up with tech only when there is evidence of a broader economic recovery and the rekindling of inflation pressure. Don't hold your breath.