US Tech Stocks on a High, but for How Long?
The US tech-heavy Nasdaq index has seen a remarkable climb of 27% since the beginning of the year, while the broader S&P 500 has also experienced a significant increase of 15%. However, it is worth noting that the same seven stocks are driving both indices: Apple, Microsoft, Google-owner Alphabet, Amazon, Nvidia, Tesla, and Facebook-owner Meta. Investors are flocking to these mega companies, betting on the potential of artificial intelligence (AI) to drive valuations. While AI is undoubtedly set to revolutionize the world, it is important to reflect on the lessons learned from the dotcom bubble of the early 2000s.
Back in 2000, the Nasdaq correctly predicted substantial gains for tech stocks over a longer timeframe of 20 years. However, it is worth remembering that the index also experienced a devastating 83% drop from its peak to its trough in less than two years. At that time, Scott McNealy, the chief executive of Sun Microsystems, expressed disbelief at the exorbitant valuation of his company, which was valued at 10 times its total revenues. McNealy highlighted the unrealistic assumptions required to justify such a valuation, including a 10-year payback period based on 100% of revenues being paid as dividends, zero cost of goods sold, zero expenses, and zero research and development (R&D) expenses for the next decade. Looking back, it is clear that these assumptions were far from realistic.
Fast forward to today, and the valuations of mega-cap AI stocks are even more astronomical. While these companies are undoubtedly exceptional, valuations do matter, and a reckoning may be on the horizon. One of the reasons for concern is the persistence of inflation and the fading hope of interest rate cuts in the US. The mega-tech stocks may have billions in cash, but they also carry substantial levels of debt, which must be serviced at rates that are at least 4% higher than a year ago. The impact of higher interest rates on earnings has yet to be fully reflected in their share prices. Additionally, it is important to note that the current rally is primarily based on expectations for AI to drive future earnings.
Traditionally, rising interest rates have had a negative impact on stocks. However, this rally has defied expectations so far. While AI undoubtedly has the potential to change lives and create successful companies, it is worth remembering that the winners of the late 1990s tech rally were not necessarily the corporate darlings of that era. The question of which companies will be the most successful in the AI era remains unanswered. The current valuations of the seven tech giants may suggest that they are the frontrunners, but this prediction is overly optimistic and premature.
A correction of 30% to 50% in tech share prices would not be unrealistic and would still leave valuations at elevated levels. It may be prudent for investors to consider taking some profits and refrain from further investment at this stage. While a major correction may come as a shock to some, it will not mark the end of investor interest in AI-related companies. It will, however, signal the end of the false start. As we navigate this ever-changing landscape, it is crucial to exercise caution and approach investments with a critical eye.
In conclusion, while the US tech stocks have experienced significant growth, it is important to consider the lessons of the past and approach valuations with caution. The potential of AI is undeniable, but it is still too early to determine which companies will emerge as the true winners in this era. A correction in tech share prices may be on the horizon, and investors should be prepared for potential volatility in the market. As always, careful analysis and prudent decision-making will be key in navigating the ever-evolving world of technology investments.
Peter Brown is the managing director of Baggot.ie