Wall Street traders are ignoring warning signs that the rally in technology stocks looks overblown.
(Bloomberg) — Wall Street traders are ignoring warning signs that the rally in technology stocks looks overblown.
Optimism that the Federal Reserve will pivot from its most aggressive interest-rate hiking cycle in four decades – a major headwind for the industry last year – has pushed the S&P 500 Information Technology Index up 19% in 2023 compared with a 7.7% gain for the S&P 500 Index. That’s info tech’s strongest start to a year relative to the S&P 500 since 2009, according to data compiled by Bloomberg. Last month alone, the sector beat the broader gauge by the most in two decades.
One valuation model, however, shows the euphoria has gone too far.
Tech stocks in the S&P 500 are trading at almost 25 times prospective earnings. To justify such a multiple, the Fed would need to cut rates by at least 300 basis points, data compiled by Bloomberg Intelligence show. That’s more than five times what the swaps market is pricing in for rate cuts this year.
“Traders are betting on a big about-face in the Fed’s interest-rate policy, but there is no certainty as to whether, and when, this will happen,” said Quincy Krosby, chief global strategist at LPL Financial. “Longer-term, the sector’s growth prospects are attractive, but not at the current valuations.”
A bleak earnings outlook for tech companies supports the skepticism. Analysts expect a 15% slump in the sector’s first-quarter profits — the third-largest decline among the S&P 500’s 11 industry groups, data compiled by Bloomberg Intelligence show.
Tech bulls have been emboldened by the possibility that the Fed is close to ending its rate hikes, pushing S&P 500 tech stocks to their best first quarter since 1998. A big chunk of those gains happened in March, when chaos in the US banking system sent traders flocking to cash-rich tech names in search of safety.
Five stocks broadly defined as megacap high-flyers — Apple Inc., Microsoft Corp., Nvidia Corp., Meta Platforms Inc. and Amazon.com Inc. — have been responsible for two-thirds of the S&P 500’s advance this year. Microsoft is due to report results this week.
Options traders, however, aren’t as optimistic as equities investors. The cost of contracts protecting against a 10% decline in the Invesco QQQ Trust, the largest exchange-traded fund tracking the Nasdaq 100 Index, is now 1.7 times more than the cost of options that profit from a 10% rally. That’s the most in a year, data compiled by Bloomberg show.
Strategists at JPMorgan Chase & Co. and Morgan Stanley agree with options traders that the tech rally looks unsustainable.
Read more: Morgan Stanley’s Wilson Says Tech Stock Rally Is Overdone
Technology stocks have been on a wild ride since the central bank began raising rates in March 2022 — tumbling for most of last year and then aggressively rebounding to start this one. Fed officials lifted interest rates by a quarter percentage point last month, bringing their policy benchmark to a target range of 4.75% to 5%. Swaps linked to the Fed anticipate around 57 basis points of cuts this year, taking the policy rate from an expected peak of 5.12% in June to 4.55% in December.
None of this is written in stone, of course, particularly with inflation still well above the Fed’s target. Strategists at Wells Fargo Investment Institute and BNP Paribas SA say the rate cuts won’t materialize until early 2024.
Read more: Fed’s Logan Says Inflation Too High, Outlines Measures to Watch
“This Fed very badly wants to avoid compounding their initial mistake of calling inflation transitory, by now declaring it dead prematurely,” Sameer Samana, senior global market strategist at Wells Fargo Investment Institute, said in an email. “So if anything, they may stay hawkish too long, as opposed to quickly pivoting to cuts. That’s an underappreciated risk in markets.”
However, history says there still may be more upside left. During the past four rate-hiking cycles going back to the mid-1990s, tech stocks have posted an average annualized return of 21%, according to Strategas Securities data. So far in this rate-hiking cycle, the S&P 500 Information Technology Index is up just 1% and being beaten by several other sectors.
“Investors now see current hikes as nearing an end after a very aggressive hiking cycle,” said Todd Sohn, managing director of technical strategy at Strategas. “That’s helped underpin the rally in tech shares this year.”
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