Has the Tech Rally Gone Too Far?

Within the short span of 2023, the leading tech stocks went from “very undervalued” to “overvalued” in David Sekera’s reading of the market. “They were the most undervalued stocks coming into 2023, but now we think they have run too far,” comments Morningstar’s chief U.S. markets strategist.

“Two-thirds of the market’s gains in the last year or so come from just a few companies,” points out Craig Basinger, chief market strategist at Purpose Investments. By mid-February, 19% of the S&P’s growth had come from the few companies that have been identified as The Magnificent Seven: Amazon (AMZN), Alphabet (GOOG), Apple (AAPL), Meta Platforms (META), Microsoft (MSFT), NVidia (NVDA) and Tesla (TSLA).

“The valuations of the Magnificent Seven are trading at multiples of 35 times forward earnings, where the historical average of the S&P’s technology sector has been 22,” highlights Philip Petursson, chief investment strategist at IG Wealth Management. Basinger also points to the historically wide spread between the valuation of the equal-weighted S&P 500 index, at 17 times earnings, and the valuation of 21 times earnings of the same capital-weighted index.

Apple’s Worth Twice as Much as the Canadian Market

And the concentration is not limited to the US market, Basinger continues. “This is a global phenomenon. If I told you to invest in the MSCI world index, you’d find that the US holds a share of about 70%. Apple alone is 4.7% of that index, which is twice Canada’s whole stock market.”

The world likely hasn’t seen such concentration since the infamous dot-com bust in the 1990s. In Canada, Nortel’s stock carved a 30% slice out of the TSX just before its fall. “With each passing day, this has the feel of being a cross between 1999 and 2007,” wrote David Rosenberg, president of Rosenberg Research in a February 12 note appearing in Yahoo Finance, “It is a gigantic speculative price bubble across most risk assets, and while AI is real, so was the Internet, and so were the high-flying stocks that populated the Nifty Fifty era.”

Basinger also refers to the Nifty Fifty era of the 1970s when 50 large corporate names dominated the S&P 500, and investors felt compelled to own stocks like those of IBM, Coca-Cola and Avon - before they fell by about 60%. “Today, people think that they just have to own NVidia; I think that’s a dangerous view,” he notes.

This Is Not Dotcom 2.0

The most frequent comparison today is to the dot-com frenzy when the NASDAQ left Earth’s orbit. Start-ups would get hundreds of millions of dollars in venture capital based on a business plan scratched out on a restaurant napkin. Just to increase the hype around its stock price, Nortel went on an acquisition spree of unproven startups. Companies with little revenue and no earnings would see their stock soar on “infinite multiples”, and pundits proposed new concepts like “price to eyeballs” to justify ludicrous valuations.

Today’s situation is very different. “In the dotcom bubble”, Basinger recalls, “many companies didn’t have earnings. Today, the Magnificent Seven may have crazy valuations, but they do have earnings.” And huge revenues.

“There are real fundamentals behind Nvidia’s rise,” says Brian Colello, technology equity strategist at Morningstar, “Microsoft and Amazon are likely to grow into their very high valuations. We think the growth is really there; it’s not based on earnings or growth that are failing to materialize. This is not a bet on start-ups that are piling up leverage and making market projections that will materialize only in ten years. This is very real.”

Basinger would agree. Even though he’s wary of the situation, he still invests in some leading tech stocks. But he threads the ground lightly. “Apple’s revenue is now US$383 billion, he points out. Now, to grow revenue by 10%, it needs to sell US$40 billion more of its wares, and it needs to open up a new market every year the size of the UK. That’s quite a challenge.”

The Main Driver is AI

The tech rally is essentially predicated on the gigantic promises made around AI, Rosenberg indicates. After the dotcom bust, which was predicated on the Internet revolution, the Web did materialize and spawn giants like Amazon and many others. But that unfolded over two decades. In this rally, the tech giants already own the fundamental keys of AI and are on their way to monetizing it. In the case of Nvidia’s graphic processing units (GPU), “demand and sales are real,” Colello maintains, “NVidia is manufacturing them as fast as it can, and cloud companies are buying them to increase their server farms to boost capacity.”

Colello has no doubt that companies will succeed in monetizing their AI abilities. He points to Microsoft which is now selling its Copilot AI assistant as an add-on to its Office Suite for US$30 per month, while Meta says that AI has helped it serve better ads to customers and increase revenue. Because of such considerations, “as analysts, we don’t see that [the present rally] as a bubble,” Colello asserts.

But until further notice, all this is happening mostly inside a rather limited congregation of companies. Nvidia is selling to the cloud services of Amazon, Microsoft and Google, while the most popular AI apps of Microsoft and Google are integrated without cost into their search engines. “While the focus of many people was entirely on things such as climate change and big evil oil, something else quietly took over: Big Tech,” wrote Martin Pelletier, senior portfolio manager at Wellington-Altus Private Counsel in the Financial Post, “This has transformed the markets, the U.S. economy and our lives in many ways that so few realize.”

AI’s Effect on Tech Still Early Days

The promise of AI as a tremendous booster of productivity and economic growth still has to spill over from Big Tech into the general corporate world. This could prove a little trickier. “We’re in the first innings of seeing the productivity gains,” Colello recognizes, “The spending is happening, but it is still unclear what the benefits will be.”

A specialist of technology history like Robert Atkinson, president of the Information Technology and Innovation Foundation, told Morningstar a few months ago “we’ll be lucky if in 10 years we get to 2% yearly productivity growth”, while Morningstar’s Head of U.S. Economics Preston Caldwell stated: “I think AI along with other factors will help push productivity growth over the next decade or so closer to 1.5%.” That would double today’s productivity growth rate, which is certainly not insignificant, but certainly not a revolution when one remembers that productivity growth in the 1960s hovered around 3%.

Atkinson’s and Caldwell’s predictions are for 10 years from now, while Big Tech must sell its AI revolution in the present day. If it succeeds, today’s stock market stampede could extend indefinitely. But if it stalls…

What Goes Up…?

Mike O’Rourke, chief market strategist at Jones Trading, who branded the “Magnificent 7” moniker, presently sees things starting to stall. “This earnings season has shown that Nvidia and Meta Platforms have both lower multiples and significantly faster growth than other Magnificent Seven names, and that is why other members will be deemed less attractive given their expensive multiples and megacap status,” O’Rourke told MarketWatch.

While NVidia and Meta are still well positioned, others are losing steam, notably Microsoft and Apple, O’Rourke observes. Apple’s earnings are expected to grow by only 1%, Microsoft’s by only 9.5%, while their multiples respectively stand at 28 and 35.

Is there still space to grow in this hyperventilating market? The Magnificent Seven are shrinking down to two, O’Rourke believes. Basinger says that “there can still be profits in this – but who knows? These things never go up to the sky and just level off. They usually stop and fall. Markets tend to overreact in both directions.”