Technology stocks have felt a bigger impact from the recent downside volatility than the broad market (S&P 500). In the last three months through Wednesday (11/21), the S&P had declined -3.21% while the Nasdaq had fallen nearly twice that, at -6.9%.
These relative declines have investors worried that tech stocks are too overvalued, and that by extension tech names could be adding a layer of vulnerability to the broader market.
But I’m not convinced just yet that technology stocks in aggregate are overvalued or in bubble territory. The key point I’d make is that often times investors are conflating the valuations of companies like Facebook, Amazon, Netflix (FAANG stocks) with the broader technology sector. But doing so doesn’t give you the full picture.
If you have concentrated positions in just a few companies like the ones mentioned above, I’d agree you might want to reconsider your positioning now. But if you’re broadly invested in technology, I wouldn’t be so worried.
Here are 4 reasons why.
1. Tech Sector Valuations are Average Relative to History – as of Q3, the tech sector was trading at roughly 29x earnings, which is pretty close to in-line with the long-term average of 28x. During the tech bubble in the late 90s into 2000, valuations were approaching 70x with several companies trading well above 100x times earnings. Those types of companies exist today, but they’re more established businesses and are not as common.
2. Tech Valuations Relative to the S&P 500 are also Reasonable – during the late 90’s in the run-up to the tech bubble bursting, the tech sector traded between at a 1.5–2x premium to the S&P 500. But currently, it’s closer to 1–1.25x.
3. Technology Companies are Still Profitable on Balance, and Solid Balance Sheets Provide Flexibility – tech companies hit an almost 90% earnings beat rate in the second quarter, and it seems likely to eclipse 90% in Q3. Balance sheets are largely in good shape across the board as well, with large cash balances and relatively low debt. This gives tech companies cushion and flexibility as macroeconomic conditions change. They could choose to increase capital expenditures, become more aggressive in pursuing mergers and acquisitions or even increase dividend payments and share buybacks.
4. Innovation is Ongoing – it’s difficult to fathom that Facebook was founded less than 15 years ago but is now valued around $400 billion. A similar story applies to Google, Facebook, Netflix, and others. We’re continually seeing innovation in the technology sector, and I’m not sure it would be very wise to bet that this innovation goes away any time soon. Technology is likely to continue to bring new efficiencies, new products, and over time, new companies. But this constant stream of innovation also means that investors must be vigilant when choosing companies—and always aware of the competition.
Bottom Line for Investors
Tech stocks have been disproportionately affected during spells of downside volatility recently, but it’s important to see these steeper drops in perspective. Through Wednesday, November 21, the Nasdaq was still better off for the year than the S&P 500, having risen 6.0% versus the S&P 500’s 4.11% gain.
I would also add that often, the areas of the market that are hurt the most during downdrafts also tend to bounce back the strongest when the market recovers – an outcome I would expect this time around as well.