Technology stocks such as those in Vanguard’s (VGT) have been the best performers not only this year but also over most of the past few years. Many of these companies are now above their pre-COVID-19 crash highs, meaning investors do not believe the current economic crisis will materially impact these firms. Of course, earnings estimates have declined which has brought forward valuations in technology firms to extreme levels.
The outperformance has been nearly consistent over the past five years. This is demonstrated well by the relative total returns of VGT and the Russell 2000 ETF (IWM) (which is my preferred benchmark since it tracks economic reality better than others):
As you can see in the ratio chart at the bottom, there has been a shift in VGT’s outperformance pattern. It was a relatively constant uptrend from 2016 to early 2020 and then shot higher during the COVID-19 crash. Since April, VGT’s performance has been in line with IWM’s as the relative performance ratio has hit a resistance level.
Importantly, technology was not hit as hard as others by the initial impact of COVID-19. Many employees were able to work at home and people have, generally, continued to purchase their items. However, these companies have record-high valuations and falling long-term growth forecasts. While most are financially healthy, quite a few are less healthy than one would expect. Indeed, the long-term top for technology may be around the corner considering the similarities between today and the 2000 “dot-com” bubble.
Is This Dot-Com 2.0?
One could easily draw comparisons in technology stocks today to that of two decades ago. VGT, currently, has a weighted-average “P/E” ratio of 28X, meaning it would take most companies nearly 30 years of income to naturally buy back their equity. Of course, most have had strong earnings growth around 15-25% over the past few years. If such growth could continue, these technology stocks would not be too overvalued.
However, this assumption is a major issue. The median company in VGT is worth $200B and there are over 300 firms in the ETF. The largest holdings are Apple (AAPL), Microsoft (MSFT), and Visa (V) with the sum market capitalization of Apple and Microsoft being over $3T. To put that in perspective, only four countries in the world have a GDP of over $3T. Personally, I have a hard time believing these near-monopolies can continue to manage double-digit revenue growth for years to come.
Additionally, long-term growth estimates have seen material declines for most of these companies over the past year. Values still range from 2-25%, but all but two of the ten largest companies in VGT (which represent over half of its assets) have seen declines in growth estimates:
In general, lower long-term growth prospects call for lower forward valuations. Normally, valuations account for variations in expected earnings growth so, logically, the valuations of these technology giants should have declined over the past year.
On the contrary, forward valuations have actually risen by double digits for all but one of these companies:
These values range from low figures below 15X to well over 30-50X with most being around or above 30X. Over a long period of time, stocks generally have “P/E” valuations around 15X, so these companies are currently priced as if they will continue strong revenue growth for years.
The Ending Bullish Factor of Long-Term Rates
So, if the long-term growth outlook of these technology stocks is in decline, why are valuations increasing? There are a few reasons that come to mind. Fundamentally, long-term interest rates are very low with the 20-year yield Treasury at 1.2%. Growth stocks are sensitive to these rates as their value is often derived from that of future cash flows (as opposed to current cash flows). With Treasury rates at extreme lows (largely due to QE purchases from the Fed), the stock-bond tradeoff favors higher equity valuations, particularly for higher quality growth firms like those in VGT.
While this concept may seem a bit esoteric, it can be illustrated by the extremely strong correlation between the relative returns of VGT to IWM and the 20-year Treasury bond ETF (TLT) to the short-term bond ETF (SHY). As you can see below, the two charts are extremely similar despite one being equities and the other bonds:
In other words, the flat yield curve and low inflation have been a major factor boosting technology stock valuations. However, these factors are both fading as the yield curve is now in a clear steepening phase (note, steepening itself usually seems equities decline in value) and inflation expectations have risen above all Treasury bond yields.
In the latter ratio chart, you can see TLT has declined in value which means the value of long-term future cash flows should follow suit. Fundamentally, this is bearish news for technology stocks, particularly considering their falling EPS projections.
Growing Irrational Exuberance
Of course, we are currently in a market that is highly detached from fundamentals. For one of the first times ever, we are in a recession and stocks are at all-time highs. Earnings forecasts are in decline, and valuations are on the rise. Many companies are insolvent and have negative working capital, and the lending market has never seen this much new volume.
Of course, one can argue this is what happens when the Federal Reserve nearly doubles a country’s monetary base (slowly built up over 200 years) over the course of a few months. There is much more cash in the system than there was months ago, so a significant portion is likely to flow into equities regardless of their valuation.
Indeed, a significant portion of Americans bought stocks with their COVID-19 stimulus check. Additionally, after retail brokers cut commissions to zero, most saw daily average trades double or triple signaling newer investors/traders are likely a major factor pushing stocks higher. Historically, when new traders flood the market, it signals a long-term top in equities. In general, well-known technology firms like Apple are a major benefactor of retail investor purchases.
A generation of investors exists that only believe stocks rise or that, if they fall, they will quickly return to past highs due to government support. Since this notion is so widespread, I am willing to bet against it, particularly in technology firms.
Overall, I believe VGT and most of its largest constituents are a solid short opportunity at today’s price. Not only are valuations at extreme levels, but fundamentals are also in decline as well as the fundamental factors boosting valuations. While the Federal Reserve is likely to continue to supply cash, they are now causing inflation to rise and the U.S. dollar to fall which is a bearish factor for growth-centric technology firms (due to future discounted cash flow valuations).
Beyond continued irrational exuberance, I see no reason for VGT to continue higher. While this factor continues to exist, it is fading as explained in “Be Warned: Market Momentum Is Fading“. Much of the reason for this bullish sentiment has been supportive actions and words by the Federal Reserve and the U.S. government. However, now that many equities are back at all-time highs, I doubt this support will continue with its recent steam.
While I am not short VGT, I am short many of its constituents including Apple, Visa, and Autodesk (ADSK) which I believe are overvalued by 50% or more. Considering the declining growth prospects of VGT and its current weighted-average valuation, I believe its forward “P/E” should be around 20X or lower. This gives us a price target of $150 to $200 which I believe will be seen in the next crash.
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Disclosure: I am/we are short AAPL,V,ADSK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.