The Nasdaq Composite, dominated by tech companies, is trading at an unusually large premium to the S&P 500.
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Technology stocks have raced higher after a terrible 2022, making them quite expensive. The time for caution has come.
The technology-heavy Nasdaq Composite index has gained about 13% this year, compared with a gain of less than 4% for the S&P 500 . Concern about banks, rather than spectacular results from tech companies, is the main reason.
Fear that more banks will fail, and that obtaining credit will be harder, is making investors worry about economic growth and keeping a lid on broader stock market gains. A weaker economy would mean less inflation, allowing the Federal Reserve to ease back on raising interest, which has sent long-dated bond yields lower, boosting the value of future profits.
That matters for tech because investors buy those growth stocks mainly for the earnings the companies are expected to deliver years from now. Lower rates boost the current discounted value of those profits, meaning investors may be willing to pay more.
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At the same time, tech companies’ relatively brisk growth makes profits a bit less sensitive to changes in demand across the broader economy.
The strong start to the year for tech is a reversal from 2022, when the Nasdaq fell 32% as the Fed raised rates to fight inflation, sending bond yields higher.
But given the recent rally, buying tech stocks may not be so safe at this point.
The most glaring reason is that they now look fairly expensive. The Nasdaq’s aggregate forward price/earnings ratio is about 25.4 times, about 44% above the S&P 500’s 17.6 times, according to FactSet. The Nasdaq usually trades at a premium, but this is a particularly wide valuation gap.
It isn’t far from that seen in August 2020, the peak of the pandemic-era rally, when the Nasdaq traded at a 48% premium to the S&P 500. For context, the Nasdaq has traded at a premium of less than 20% at times during the past decade.
To be sure, the Nasdaq’s so-called PEG ratio, a measure that divides the price/earnings multiple by the rate of earnings growth so that the valuation can take into account how fast profits are growing, is relatively appealing. With a price/earnings ratio of 25.4 times and aggregate per-share profits expected to grow at 17% annually for the next three years, the figure comes out to about 1.5 times.
That’s fairly low, considering that the S&P 500 trades at a PEG ratio of just over two times. At current levels, investors are paying less for the earnings growth the Nasdaq will deliver than for the anticipated profit growth for the S&P 500.
A counterargument is that Nasdaq’s PEG is only as low as it looks if the earnings growth is actually as high as Wall Street expects it to be. Part of the strong expected growth for tech comes from a just over 20% increase in EPS for 2024 after what could be a tough 2023. It would decline to 15% by 2025.
The growth rates of many tech trends, such as e-commerce, digital payments, entertainment streaming, and even cloud services, are still high, but decelerating.
“These mega cap [tech] companies are subject to the law of large numbers,” said Doug Peta, chief U.S. investment strategist at BCA Research. “It’s difficult to keep growing at a fast rate.”
Even if tech remains particularly expensive, the short term could bring more of a rally. Banking’s problems should drag on the stock market for some time, especially if evidence builds that difficulty in borrowing is hurting the economy.
That would drive more money into tech names. “One thing that helps growth’s [tech stocks’] cause is that the worries for the broader market have emanated from worries in one particular component of the market, the banks,” Peta said.
The problem is that while buying now is a bet that the tech trade has a little more juice in it for the near term, the sector looks way less attractive now than it did a few months ago. It is far more vulnerable to poor performance.
Write to Jacob Sonenshine at [email protected]
