HIgher Rates Causing Investor Skepticism Towards Tech Valuations

Innovation like generative AI sparked venture investor enthusiasm, but low interest rates enhanced the potential profitability of those longer term investments. 

The Fed's decision to keep interest rates high have made the return on those investments less certain which has, in turn, raised investor perceptions of current tech valuations. JL 

Karen Langley reports in the Wall Street Journal:

 A growing expectation that the Federal Reserve will keep interest rates higher for longer threatens to dim the outlook for indexes like the S&P 500 that are heavily influenced by tech. Investors’ yearslong enthusiasm for tech shares was fueled not just by innovation at software and hardware companies, but also by ultralow interest rates that made the future profits promised by those companies especially valuable. Traders were willing to pay higher multiples of a tech company’s near-term earnings to share in its far-off growth. Investors to look with renewed skepticism at the valuations commanded by the market’s leaders. "We just think the market's a little rich."

Technology stocks have powered the 2023 market rally—and become increasingly expensive in the process. 

Now, a growing expectation that the Federal Reserve will keep interest rates higher for longer threatens to stifle the trade, potentially dimming the outlook for indexes like the S&P 500 that are heavily influenced by tech.

That is because investors’ yearslong enthusiasm for tech shares was fueled not just by innovation at software and hardware companies, but also by ultralow interest rates that made the future profits promised by those companies especially valuable. Traders were willing to pay higher multiples of a tech company’s near-term earnings to share in its far-off growth.

Their calculations changed last year when the Fed began aggressively lifting interest rates in a bid to tame inflation. By the end of 2022, the S&P 500’s tech sector had slumped 29%, becoming cheaper relative to earnings and underperforming the S&P 500 for the first year since 2013.

This year, excitement about advances in artificial intelligence and bets that the Fed would start cutting rates sooner rather than later sent tech stocks again bounding higher.

But a stubborn streak in inflation data and a surprisingly resilient economy have pushed out the date at which markets expect rate cuts, causing investors to look with renewed skepticism at the valuations commanded by the market’s leaders.

“We just think the market’s a little rich,” said Max Wasserman, co-founder and senior portfolio manager at Miramar Capital. “Now if you take technology out, we think the market is much more reasonably valued.”

Wasserman said his firm recently bought shares of industrial and financial companies including General Dynamics and BlackRock.

This week all eyes will be on the next meeting of the Fed’s rate-setting committee for insight into where monetary policy goes from here. The markets are all but certain that central-bank officials will hold rates steady Wednesday but are divided on the possibility of another increase later this year.

Cracks have emerged in the tech trade. Shares of 

Apple AAPL 0.62%increase; green up pointing triangle

, the largest company in the S&P 500 by market value, have declined 6.8% this month, while Nvidia, the index’s top performer for 2023, has retreated 11%. They are still up 35% and 200% in 2023.

The dual drops have helped pull the technology sector to a 4.3% decline in September, putting it on pace to lag behind the S&P 500 by the widest margin in a month since November 2018, according to Dow Jones Market Data. The index is down 1.3% in September.

Many investors were surprised by the force with which the stock market burst out of the gate in January. Through August, the S&P 500 notched a total return, which includes dividends, of 19%.

Technology and similar market segments accounted for nearly all of it.

The technology sector, which houses Apple, Microsoft and Nvidia, contributed 59% of the index’s total return through August, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. The consumer discretionary segment, home to Tesla and Amazon.com, and the communications services group, which includes 

Alphabet GOOG -0.09%decrease; red down pointing triangle

 and 

Meta Platforms

, accounted for a combined 36%.

Traders have been pushing back their predictions for when the Fed moves rates below current levels. On Friday they assigned a 57% probability to a lower Fed target rate by June 2024, down from the 81% probability they assigned a month earlier, according to CME Group’s FedWatch tool.

Jensen Huang’s Nvidia is the S&P 500 index’s top performer for 2023. PHOTO: DAVID PAUL MORRIS/BLOOMBERG NEWS

Some analysts saw clues in last week’s inflation data that the Fed might keep rates elevated. Consumer prices rose in August at the fastest pace in more than a year due to an increase in energy costs. When the volatile categories of energy and food were excluded, core prices rose 0.3%, above the 0.2% predicted by economists.

“It bolsters the idea that we’re going to be higher for longer because there are still pockets that are pretty stubbornly high,” said Julie Biel, portfolio manager and senior research analyst at Kayne Anderson Rudnick, an investment-management firm.

A prolonged period of high interest rates could spell trouble for stocks, especially those with lofty valuations. Investors who for years found few alternatives to the equity market can now earn 5% with little risk in a money-market fund. The yield on the two-year U.S. Treasury note settled Friday at 5.030%. That newfound competition could weigh on what investors will pay in the stock market for a potential slice of future company earnings. 

The year’s rally has left tech stocks looking expensive relative to history. The information-technology sector traded late last week at 25.5 times its expected earnings over the next 12 months, up from 20 at the end of last year and above a 10-year average of 18.5, according to FactSet.

Nvidia was priced at 31.7 times its projected earnings, down from where it started the year because analysts have lifted their profit estimates by even more than the company’s tripled share price. Microsoft traded at 29.9 times forward earnings and Apple at 26.9 times. 

The big tech stocks in the consumer-discretionary sector look even pricier. Amazon traded at 50.1 times projected earnings and Tesla at 63.8 times.

“Markets are just plain over-extended,” said David Bahnsen, chief investment officer of Bahnsen Group, a wealth-management firm. “There is too much euphoria in the big seven tech companies.”

The S&P 500, meanwhile, commanded 18.9 times its forward earnings, up from 16.8 at the end of December and above a 10-year average of 17.7.

Some investors are betting that stocks in other parts of the world have more promising potential returns.

 

John Davi, chief executive and chief investment officer at Astoria Portfolio Advisors, said his firm holds larger positions than its benchmark in European and Japanese stocks and a smaller position in U.S. large-cap stocks. The Stoxx Europe 600 index traded last week at 12.5 times projected earnings, while the Nikkei 225 traded at 18.6.

“There’s a new playbook for a higher real rate world and a higher inflation world,” Davi said. “Just because something worked the last 10 years doesn’t mean it’s going to work in the years to come.”