Hopes that inflation is subsiding are fueling a surge in battered technology and megacap stocks, though some investors believe still-high valuations and doubts over the companies’ earnings outlooks may make a sustained reversal elusive.
The tech-heavy Nasdaq Composite index rose 8.1% this week to notch its biggest weekly gain since March, one of several eye-popping market moves that also saw Treasuries soar and the U.S. dollar tumble after Thursday’s softer-than-expected inflation data spurred hopes the Federal Reserve could temper its rate hikes.
Despite those recent gains, some investors are hesitant to jump on the rebound in shares of companies such as Amazon.com Inc, Microsoft Corp and Google-parent Alphabet Inc, which have stumbled badly this year after leading markets higher for more than a decade.
Few believe the Fed will be swayed by a single inflation print, and past rebounds fueled by Fed-related optimism have crumbled this year after discouraging economic data or pushback from policymakers.
At the same time, tech sector valuations remain well above the overall market, while analysts are dimming their profit outlooks for the group.
While lower interest rates could drive near-term demand for the stocks, “we think that there is still going to be some valuation and earnings concern,” said James Ragan, director of wealth management research at D.A. Davidson. “We are not really looking for those sectors to retake the leadership of the market.”
In the coming week investors will be watching a spate of economic data, including retail sales numbers on Wednesday, for more clues on whether the Fed’s monetary policy tightening is cooling the economy.
Tech and growth stocks have been hit hard this year, with the Russell 1000 growth index still down 25% for 2022, compared to a 16% decline for the S&P 500 and a 7% fall for the Dow Jones Industrial Average. Tech sector funds have seen $14.2 billion in outflows so far this year, putting them on track for their first year of outflows since 2016, according to Refinitiv Lipper data.
The price declines have moderated valuations, with the S&P 500 tech sector trading at about 21 times forward earnings estimates versus 28 times at the end of 2021, according to Refinitiv Datastream. That level, which is still above the 17 times earnings commanded by the S&P 500, is still too lofty for some investors.
“The (megacaps) trade at quite a premium to the S&P,” said Andrew Slimmon, U.S. equity portfolio manager at Morgan Stanley Investment Management. “There are a series of stocks that will do much better than the megacaps because they have re-rated significantly lower.”
Many of the major tech and growth companies, including heavyweights such as including Amazon, Microsoft, Alphabet and Facebook parent Meta Platforms, also recently posted third-quarter earnings reports that soundly disappointed the market.
Tech and tech related companies that represent less than one-fifth of the S&P 500 have so far accounted for over half of the negative profit revisions for the fourth quarter, according to Credit Suisse.
Still, some investors are considering increasing their positions in tech and megacap stocks if further evidence of easing inflation presents itself.
One key factor is whether Treasury yields, which move inversely to prices, continue this week’s stunning decline. Higher yields can weigh heavily on tech and growth stocks, whose valuations tend to be based heavily on future profits that are discounted more severely as yields go higher.
The U.S. 10-year yield dropped to a five-week low of 3.818% on Thursday after notching its steepest one-day decline since daily fall in more than a decade.
King Lip, chief strategist at Baker Avenue Asset Management, described Thursday’s CPI news – with the annual increase below 8% for the first time in eight months – as a “big deal.” If bond yields continue to fall, “the pace at which people are reducing their exposure to these large-cap tech names is going to slow down,” he added.
The firm has been underweight large-cap tech and growth stocks, preferring small cap and value shares, Lip said.
Ultimately, much will depend on whether inflation shows more signs of cooling. The Fed will get one more CPI reading before the bank’s policymakers gather again in December.
“If inflation continues to subside, tech is a good place to invest right now,” said J. Bryant Evans, portfolio manager at Cozad Asset Management. “They certainly could lead the way out in an environment where the Fed is reducing these increases they have been doing on interest rates.”
