Chances for a Santa Claus rally have improved after the Federal Reserve’s vice chairman recently suggested the central bank may adopt a neutral stance on interest rates if growth in the US economy is moderating, but any way you cut it, excess liquidity and an ultra-low interest rate environment have muddied the waters where equity valuations are concerned. So it remains to be seen whether the sell-off amounted to a correction or a harbinger of a sustained markdown – but the question over tech stocks is now more pertinent after their sell-off gathered momentum this week.
The Nasdaq 100 Index dropped 8.7 per cent in October, the sharpest monthly decline in a decade, with valuations for high-profile names such as Amazon (US:AMZN) and Netflix (US:NFLX) bearing the brunt. Apple (US:AAPL) and Facebook (US:FB.) continued the downward spiral in the early part of this week, with Mark Zuckerberg’s embattled brainchild hitting a near-two-year low, while telecoms analysts are starting to wonder whether sales forecasts for Apple may have to be revised following negative speculation over iPhone order numbers. If that wasn’t enough, software and semiconductor stocks also took a beating under heavy selling pressure – it’s almost as if a bubble had burst.
Any such notion, however, disregards the fact that we’re in a very different place to where we were at the time of the dotcom bubble; many of the tech sub-sectors, which may have seemed esoteric at the time, have matured. Admittedly, relative value metrics for tech stocks might still seem lofty, if not preposterous, by comparison with most other industrial sectors. And the average price/earnings (PE) rating for tech stocks, though down a quarter in absolute terms from the height of 1995-2000 tech boom, is still double the average rating for the S&P 500.
A key difference, however, is that contemporary valuations are largely predicated on earnings and revenue growth; investors aren’t blindly piling in on open-ended (and unknowable) assumptions on future growth rates. So, although tech stock valuations have grown to represent an increasingly larger proportion of the overall value of the S&P 500, their representative earnings have continued to trend higher, and now represent around a quarter of the S&P aggregate. That relationship certainly didn’t exist at the turn of the millennium – as investors found to their cost.
It should be remembered that while tech stocks further down the food chain have also taken a beating, the market’s focus remains on the FAANGs (Facebook, Apple, Amazon, Netflix and Google). Not that long ago this bloc of tech mega-caps might have seemed unassailable – but no longer. If nothing else, experience shows that digital disrupters are also vulnerable to disruption from new market entrants or evolving technologies. It’s an inherent risk factor in the digital era, one that necessitates constant innovation. Think of cash that corporations such as Google (US:GOOGL) have outlaid to stay in the game in rapidly evolving tech fields such as artificial intelligence, robotics and additive manufacturing.
But not everyone wants to develop ‘a killer app’ or software programme only to see it swallowed whole by one of the FAANGs, although the attrition rate for tech stocks is also bound up with their ability to muster and then harness capital. That’s where a holding conglomerate like Japan’s SoftBank (TYO:9984) has seen an opportunity; by identifying the most promising start-ups in growth sectors, and then allowing them to focus primarily on business development by effectively removing capital constraints.
