Talk of a tech bubble is back with the NASDAQ Composite Index (“NASDAQ”) flirting with its dot-com era high.
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It has taken the technology-heavy index fifteen years to recover the ground lost in the aftermath of the Internet stock crash of 2000. Is the index headed for a second slump, or are things different this time?
On March 20, 2015, the NASDAQ hit 5,026, just 22 points below its prior peak reached at the height of the dot-com bubble of 2000. Investors’ resolve was put to the test as the index breached the psychological threshold of 5,000. But price really is just a number. What matters is the underlying value, and from our measures, current price levels seem justified.
Below we examine the NASDAQ’s recent activity for classic warning signs of an asset bubble:
1. A rapid rise in prices
2. A sharp decoupling of price and underlying value
3. Excessively bullish sentiment (often spurred by new technology or innovation)
Slow and steady wins the race
The NASDAQ’s ascent since the financial crisis has been slower and steadier than its surge during the Internet bubble that lasted from 1997 to 2000.1 During both the tech bubble and the post-recession period, the NASDAQ rose approximately 80%. (Figure 1) The key difference is the amount of time it took: six months in the former, and almost three years in the latter.
The gradual rise is reflected in the index’s low volatility in the more recent period. (Figure 2) Relative to the S&P 500 (SPX), the NASDAQ’s volatility is subdued, and in fact, about 60% lower than the level it reached during the tech bubble. No red flag here.
Price vs. Value
Since technology has the largest weight in the index, we pay close attention to valuations in this sector. Technology is a fast-paced industry that thrives on innovation and response to ever-evolving consumer demands. It is no surprise that companies in this sector tend to exhibit above-average growth relative to the broader market.
Therefore, an appropriate valuation measure for technology stocks is the PEG (price-to-earnings growth) ratio. This measure is simply the price-to- earnings multiple divided by the earnings growth that a given company generated for that particular time period. The PEG ratio for the NASDAQ currently sits below its long-term average. (Figure 3) Also, this ratio has stabilised since early 2014 and is about 26% below the peak reached during the latest financial crisis.
Source: Bloomberg, Factset, as of March 22, 2015. Past performance does not guarantee future results. An investment cannot be made directly in a market index.
In addition, tech companies hold higher cash balances now than before, as shown in lower price-to-cash flow multiples, which makes them subject to much less liquidity and solvency risk. These companies have also shown a greater willingness to return cash to shareholders. The dividend yield for the NASDAQ has risen to 1.3% from 0.1% in 2000.2
Even though technology still represents 46% of the index, the sector composition of the NASDAQ has changed since the early 2000’s. (Figure 4) Consumer discretionary and health care now represent a higher proportion of the index, which diversifies the index’s risk exposure.
With this in mind, it is also useful to consider other traditional valuation measures, in addition to the PEG. Comparing current valuations to those during the tech bubble increases our conviction that the NASDAQ is reasonably priced. (Figure 5) Five different price multiples suggest that current valuations are more than 50% cheaper than they were during the bubble. Specifically, the P/E multiple currently stands at 28.9 versus 189.8 in 2000.
Sector valuations vary within the NASDAQ index. (Figure 6) For example, the NASDAQ Telecom Index is trading at a discount based on all four valuation measures. However, the NASDAQ Financials ex Banks Index trades at a premium based on all price multiples in the table shown. Also, biotech companies are richly valued and most susceptible to a sell-off. Investors who still desire exposure to this subsector are better served to choose companies with strong cash flows. Investors should be selective within the NASDAQ and pay very close attention to fundamentals when sector positioning.
Overall, current valuations seem to suggest that prices are built on strong fundamentals, not just hope.
Too much hype?
While equity markets overall have performed well in recent years, sentiment does not seem overly bullish. Confidence readings, such as the AAII US Bullish sentiment indicator, do not show signs of the irrational exuberance seen in the Internet boom. (Figure 7) The current three-month moving average bullish reading stands at a significantly lower level than during early 2000. Equity ownership, taken as a whole, is also not as elevated as it was back in 2000. (Figure 8) Current equity ownership as a percent of total assets stands at 14%, roughly in line with the 20-year average of 13%.
Looking at the NASDAQ specifically, investors are warming to the technology sector due to strength in the initial public offering (IPO) market. According to a study done by Pricewaterhouse Coopers (PwC), the 2014 IPO market for the global tech industry was the strongest in 10 years.4 Some of the factors that contributed to this strength are improved conditions in Europe, repressed volatility, stronger capital markets and the opening of China’s IPO market.
Chinese search engine giant Alibaba raised the largest-ever international IPO, standing at $21.8 billion. The PwC report pointed out the broad participation in the technology IPO across the globe, making year 2014 different from other years. Despite all this good news, the 275 IPOs that occurred in 2014 do not come close to the levels seen in 1999 and 2000, 486 and 406, respectively. So while 2014 was a healthy year for new companies, the overconfidence that led to a crash in 2000 seems to be absent this time.
Technology sector: reasons to be bullish (but not overly so)
The technology sector can be considered a call option on future productivity. As we discussed in the 2015 Outlook, productivity growth has been slow to recover since the financial crisis, but we expect this trend to reverse. Human technological progress is not dead.
As the world economy gains momentum and businesses become more confident about spending globally, they will start purchasing new technology to drive efficiency gains. The tech investment as a share of GDP in the US is near its historic low,5 suggesting that there is a significant pent-up demand for technology. Finally, valuations in the sector look reasonable, at just slightly above their 10-year average.6
Investing involves risk including loss of principal. Sector investing may not be appropriate for all investors and may involve a greater degree of risk and increased volatility. An investment cannot be made directly in a market index.
1 Source: Bloomberg
2 Source: Bloomberg, as of March 22, 2015.
3 Long -term average calculated for all the price multiples for the last 20 years for the NASDAQ Computer Index and NASDAQ Industrial Index. Long-term average calculated for all the price multiples since January 2, 2002 for the NASDAQ Telecom Index, NASDAQ Financial ex Banks Index, NASDAQ Transportation Index, and NASDAQ Insurance Index. Note that P/E has been calculated since April 30, 2004 for the NASDAQ Telecom Index. Long-term average calculated for P/S, P/B and P/Cash flow for since March 1, 2001 and since December 31, 2009 for P/E for the NASDAQ Biotechnology Index.
4 Source: Pricewaterhouse Coopers (PwC), as of January 30, 2015.
5 Source: Bloomberg, as of December 31, 2014.
6 Source: Bloomberg, as of March 31, 2015.