US valuations look extremely punchy, relative to history and relative to earnings. However, strength this strength is almost entirely down to one sector: technology.
- A handful of technology stocks have led markets higher this year, but valuations now look stretched
- Investors have started to reappraise these high valuations and technology stocks are starting to sell off
- While it is possible to justify high valuations, this contributes to the market’s current vulnerability
Facebook, Amazon, Apple, Microsoft and Google have added more that £500bn to their market capitalisations since the start of the year. The performance of a handful of technology stocks accounts for almost all the growth in the US stock market for the year to date.
But there are signs that investors are starting to reappraise these valuations. This seems to have been driven by a report suggesting that this year’s new iPhone will have slower download speeds than many of its rivals. This has sent many technology to a two-month low. Is this mini-bubble bursting and, if so, what are the implications for the rest of the market?
There are plenty of sound reasons for the strength of technology stocks. These stocks are growing really, really fast. Amazon grew its revenues at 23% last year. That gives it enormous capacity to move on and disrupt new areas – among its targets are self-driving cars and drone technology. Companies such as Facebook are subject to network effects, which increase their dominance. In a low growth world, companies that can deliver this type of earnings growth are valuable.
However, these are still uncomfortable valuations and the market has started to reassess. This is troubling for a number of reasons. The end of a bull market has historically been marked by a narrow focus on a few sectors or stocks. This may be what is happening here. In the absence of growth in other sectors, investors are gravitating to proven growth stocks, but eventually valuations will get too high.
There is a danger that any slump in technology valuations will bring everything else down with it. Markets are fragile. From Donald Trump, to Chinese debt, to Brexit, there is much to be worried about, and valuations do not provide much room for manoeuvre. Equities continue to score only as the least worst option, but this may not last forever.
This is not a second technology crash. Valuations in the technology sector are supported by real earnings and cash flow. However, that does not mean that the market will continue to support them at their current levels. It is another vulnerability in an already fragile market.