Technology Stocks Soaring Despite High Prices

Technology stocks are currently on a relentless upward trajectory, with the Nasdaq 100 index experiencing a remarkable 20% surge since late October. Strikingly, these stocks continue to climb even without the usual factors that typically push them higher.

The Nasdaq 100 is an index dominated by fast-growing nonfinancial companies listed on the Nasdaq Composite. Interestingly, it has shown positive growth this year, and during Thursday's trading, it was up more than 1% at one point. This is notable considering that the 10-year Treasury yield has risen to just over 4.1%, up from below 3.9% at the end of 2023. Ordinarily, technology stocks tend to rise when bond yields fall, and vice versa. This is because higher long-term bond yields diminish the value of future profits, and growth-oriented companies are typically valued based on their anticipated future earnings.

Surprisingly, tech stocks are rallying in spite of the upward movement in bond yields. Market expectations play a part in this rally as investors anticipate falling yields due to potential interest rate cuts by the Federal Reserve. These rate cuts are seen as necessary measures to prevent a significant decline in economic growth and inflation. However, there is a notable concern that the Federal Reserve might not cut interest rates as much as the stock market desires. The Fed's hesitation stems from inflation levels slightly exceeding the target of 2% and the overall strength of the economy. Consequently, bond yields may not decline enough to sustain the continued surge of tech stocks.

Moreover, technology stocks appear to be overpriced at their current levels. The Nasdaq 100 is currently trading at a multiple of approximately 25 times analysts' projected earnings per share for the upcoming year. This multiple has increased from about 21 times at the beginning of the recent rally, according to FactSet data. Although the present multiple remains below historical highs, it is still considered too high considering current yield levels. This price-to-earnings multiple indicates that investors would receive $1 of earnings per share for a year for every $25 invested in the index, resulting in a 4% yield. However, this yield is lower than the 10-year Treasury yield – a departure from the typical scenario where stock indexes tend to yield more than secure government bonds.

Evaluating Tech Valuations

While some assessments suggest that tech valuations are reasonable, there is another perspective that portrays the sector as overpriced. Just a few months ago, the 10-year yield stood at 4%, and during that time, the index struggled to surpass a price-to-earnings ratio of 25. Late in 2008, when the bond yield was around 4%, the Nasdaq 100 traded at approximately 18 times earnings.

Tech enthusiasts argue that the sector is witnessing aggressive earnings growth. Analysts predict that the index's aggregate EPS will experience a 15% annualized increase over the next couple of years, including a substantial sales growth of 12%. Leading this growth are companies like Nvidia, Microsoft, and Meta Platforms, utilizing artificial intelligence-driven product enhancements to capture more market share. Consequently, this surge in earnings might drive an increase in profit margins, resulting in overall bottom-line improvements. Thus, some may argue that tech stocks could reasonably trade at a premium compared to the S&P 500, which is projected to see only an 11% earnings growth.

However, the problem lies in the fact that the argument for profit growth does not necessarily indicate that tech stocks are currently undervalued—and investors have already heavily invested in these stocks. According to Bank of America's fund manager survey, which encompasses trillions of dollars of assets under management, tech now ranks as the second largest overweight among portfolio managers out of 16 equity groups. This suggests that there are likely very few potential buyers left to further drive up the sector, while many investors may choose to sell and take profits soon. As a result, tech companies may need to surpass fourth-quarter earnings estimates significantly to continue gaining ground, as anything less impressive could lead to declines.

Moreover, technical trends reinforce the possibility of a pullback. FactSet data reveals that the Nasdaq 100 currently sits approximately 12% above its 200-day moving average price. Historically, the index has retreated from similar levels in the past.

Considering these factors, individuals who have profited from tech investments may consider selling at this point and exploring more affordable opportunities.