The technology sector has been a darling of the stock market for some time now. Still, after a rocky 2022, the stocks have surged to high valuations, causing some investors to take a step back and consider the potential risks of investing in the tech industry.
Nasdaq Composite Index vs. S&P 500
The technology-heavy Nasdaq Composite Index has had a solid start to the year. It gained about 13%, compared to the S&P 500’s gain of less than 4%. However, the tech sector‘s outperformance is not due to spectacular earnings from tech companies but rather concerns about banks.
Investors worry that more banks will fail, making obtaining credit harder and negatively impacting economic growth. This fear has kept a lid on broader stock market gains.
A weaker economy would mean less inflation, allowing the Federal Reserve to ease back on raising interest rates, which would lower long-dated bond yields, thus boosting future profits’ value.
Tech Investors Buy Growth Stocks for Future Earnings
Investors typically buy growth stocks, such as those in the tech sector, mainly for the earnings companies are expected to deliver years from now. Lower interest rates boost the current discounted value of those profits, which means investors may be willing to pay more.
Additionally, tech companies’ relatively brisk growth makes profits less sensitive to changes in demand across the broader economy.
2022: A Terrible Year for Tech
2022 was a terrible year for the tech industry, with the Nasdaq falling 32% as the Fed raised rates to fight inflation, sending bond yields higher.
2023: A Strong Start for Tech but with Risks
The strong start to 2023 for the tech sector is a reversal of fortune from 2022. However, given the recent rally, buying tech stocks may not be so safe.
The most glaring reason is that tech stocks now look fairly expensive. According to FactSet, the Nasdaq’s aggregate forward price/earnings ratio is about 25.4 times, approximately 44% above the S&P 500’s 17.6 times. The Nasdaq usually trades at a premium, but this is a wide valuation gap.
Nasdaq’s PEG Ratio
The Nasdaq’s PEG ratio, which divides the price/earnings multiple by the earnings growth rate, is relatively appealing. With a price/earnings ratio of 25.4 times and aggregate per-share profits expected to grow at 17% annually for the next three years, the figure comes out to about 1.5 times.
That’s fairly low, considering the S&P 500 trades at a PEG ratio of just over twice. At current levels, investors are paying less for the earnings growth the Nasdaq will deliver than for the anticipated profit growth for the S&P 500.
Tech Trends’ Growth Rates are Decelerating
The growth rates of many tech trends, such as e-commerce, digital payments, entertainment streaming, and cloud services, are still high but decelerating.
Banking’s Problems Could Boost Tech
Even if tech remains particularly expensive, the short term could bring more of a rally. Banking problems should drag on the stock market for some time, mainly if evidence builds that difficulty in borrowing is hurting the economy. That could drive more money into tech names, as investors seek alternative investments.
Caution for Tech Investors
Despite the potential short-term rally, it’s important to note that the tech sector looks less attractive now than it did a few months ago. As a result, it is far more vulnerable to poor performance, and investors should be cautious before making any investment decisions.
One counterargument is that Nasdaq’s PEG ratio is only as low as it looks if earnings growth is as high as Wall Street expects. Part of the strong expected growth for tech comes from a just-over 20% increase in earnings per share for 2024 after what could be a tough 2023. It would decline to 15% by 2025.
The bottom line is that while the tech sector has delivered impressive gains in recent years, investors should approach it cautiously at current valuations. While the Nasdaq may continue to outperform the S&P 500 in the short term, the potential risks of investing in the tech sector at this stage outweigh the potential rewards.
Final Thoughts
The technology sector has stood out for some time, but recent valuations have raised investor concerns. So while it may be tempting to jump on the tech bandwagon, it’s essential to consider the potential risks and exercise caution before making any investment decisions.
In summary, the time for caution has come, and investors should weigh the risks and rewards of investing in the tech sector carefully. The tech sector’s high valuations and potential vulnerability to poor performance should be factored into investment decisions. In addition, investors should seek professional financial advice to guide them in their investment journey.
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