Tech bubble? No, but be selective with FAAMNG

The information technology (IT) sector currently trades at a P/E of 25x consensus forward EPS estimates, a +17% uptick from the beginning of the year. Valuation is now the highest in the post-dotcom era. While valuations have moved up, we wouldn't call it a "bubble." On some metrics, the IT sector looks appropriately valued relative to other sectors given current earnings expectations. We have a neutral view on the IT sector.

But just looking at the IT sector doesn't paint the full picture. Investors are clearly paying up for growth stocks more broadly. Growth stocks now trade at the highest valuation relative to their value counterparts in nearly two decades. Over the last forty years, only during the dotcom bubble have growth stocks been more expensive relative to value stocks. Value stocks could assume market leadership if the economy gets fully back on its feet. Right now we have a neutral view between growth and value.

Tech appears expensive, but it’s probably not a bubble

IT bulls point toward secular trends that support continued long-term growth in IT spending. Whether it is 5G wireless, artificial intelligence, cloud computing, Big Data, artificial/ virtual reality, or e-commerce, all signs continue to point towards a long runway of growth that, if anything, has been accelerated by the COVID-19 global pandemic.

Bears of a certain age remember the same arguments from the late 1990s and point with foreboding to the -78% March 2000 peak to November 2002 decline in the NASDAQ, and point towards the need for continued strong growth and a benign interest rate environment as necessary conditions for valuations.

Finally, a narrow market dominated by the mega-cap FAAMNG complex (Facebook, Apple, Amazon, Microsoft, Netflix and Alphabet) seems to put the market at risk from an “inevitable rotation” away from the market’s technology darlings and back to cheap value stocks across other more-depressed sectors.

In comparing the IT sector’s current valuation to its history and to other sectors, we think it is hard to land in the bubble camp. Using the tech-heavy NASDAQ composite as a proxy, valuations are clearly well below late 1990s levels. Furthermore, the IT sector looks appropriately valued relative to other sectors given current expectations. The sector's P/E relative to the market is not very elevated, and nowhere near levels reached during the dotcom bubble. So, IT valuations have certainly expanded, but perhaps deservedly so. Earnings estimates have held up remarkably well even as estimates for other sectors cratered. In addition, the leading IT companies enjoy robust balance sheets and strong cash flows.

Watch your weight(s)

After the significant outperformance of growth in general and FAAMNG in particular, many investors' portfolios may be heavily skewed towards recent winners. For example, the top five companies in the S&P 500 (Apple, Microsoft, Amazon, Alphabet, Facebook) now account for nearly 22% of the index. Strong performance however, doesn't necessarily mean that stocks should be sold. But narrowly concentrated performance does mean that portfolios may be less diversified and therefore more risky (both on the upside and downside) than they might seem. In addition, investors that have too much exposure to growth stocks, which are dominated by this group could be at risk if value stocks start to assume market leadership. Investors should understand the exposures they have and make any adjustments to align portfolios with target weightings and to reduce single stock risk where appropriate.

Be selective with FAAMNGs

The so-called FAAMNG complex collectively has gained nearly 35% year-to-date, while the rest of the S&P 500 has declined nearly 4%. Owners of this narrow stock group have benefited from this outsized performance, and we remain positive on the underlying trends, but we believe it is time to be increasingly selective given valuation, our view of fundamentals, and the importance of reviewing portfolio holdings.

To download the full US equities report, “Tech bubble? No, but growth appears expensive; be selective with FAAMNG”, sign into UBS Online Services and click on the "Research" tab and then select "Equities".

US equities report published on 27 July 2020 by David Lefkowitz, CFA, Head of Equities Americas; Kevin Dennean, CFA, Technology & Communication Services Analyst Americas; Robert Samuels, Consumer Analyst Americas; Matthew Tormey, Associate Equity Strategist Americas; Reid Gilligan, Equity Associate Analyst Americas

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