If earnings continue to grow at a healthy pace, the sector’s sensitivity to bond yields poses a challenge.
After two years of robust performance, US tech companies have stalled this year, with the Nasdaq 100 dropping more than 20% since early January. The index’s 12-month price-to-earnings (P/E) ratio has fallen sharply, from 30x in 2021 to around 21x currently. Is this level attractive, or is further decline possible? Historically, the Nasdaq 100 is still trading at a slight premium to the pre-pandemic P/E ratio (19.2x on average between 2016 and 2019). Since market conditions were slightly different at the time, a dividend discount model can help determine if the Nasdaq 100 is at its fair value. The value of a stock index mainly depends on three factors:
- Expected earnings, as shares are purchased for their future cash flows;
- Bond yield, through the discount factor of future earnings;
- Volatility, through the equity risk premium.
A dividend discount model applied to the Nasdaq 100 indicates that the market is currently pricing in:
- Profit growth of 5.5% per year
- Bond yields equal to 3%, which matches the yield on long-term US Treasuries.
- Volatility close to 30% this year, before a return to around 15%. These parameters translate into a fair value of approximately 12,500 points and a 12-month price/earnings ratio of 21x.
WHAT TO EXPECT?
The first quarter earnings season was generally positive, including for US technology stocks. Although profit margins are likely to be squeezed in the future, inflation should support earnings growth in nominal terms. But in the current environment, the short-term prospects of tech companies matter less than bond yields. The latter have been the main drivers of stock market multiples for growth stocks for some time, a situation that could continue. The more than 20% drop in the Nasdaq 100 is mainly due to the fact that US bond yields have doubled since the start of January – they are now around 3%, compared to 1.5% at the start of the year. Several scenarios are possible:
THE DOWNSIDE SCENARIO: HIGHER INFLATION
If inflation remains high, the Fed could be forced to raise rates beyond market expectations, which could push the yield on US 10-year bonds towards 3.5%. In such a scenario, the theoretical value of the Nasdaq 100 is likely to drop to 10,000 points, which corresponds to a multiple of 17x (17 times forward earnings).
THE FAVORABLE SCENARIO: CONTROLLED INFLATION
At this point, the Fed’s central scenario is for inflation to slow below 3% in 2023. If economic growth continues and equity market volatility stabilizes around 20%, the fair value of the Nasdaq 100 should fall within the 13,500-14,000 range.
Many other scenarios are possible, however, including that of a recession, but this does not correspond to our base case at this time. A sensitivity analysis of the theoretical value of the Nasdaq 100 to bond yield and volatility demonstrates that bond yields play a critical role in the valuation of tech stocks – a 50bp rise in bond yields wouldn’t even be offset by a pullback 10% volatility (10 volatility points). Any change in the earnings forecast for the next 12 months would also affect the Nasdaq, but in a more linear fashion (a 1% increase/decrease in 12-month earnings growth results in a 1% increase/decrease in the index ).
The technology sector therefore faces headwinds: if earnings continue to grow at a healthy pace, the sector’s sensitivity to bond yields poses a challenge. Despite the recent market downturn which offers a better entry point in terms of valuation, we recommend caution on technology stocks, which are likely to be penalized by a further rise in bond yields. Investors should stay away from expensive tech companies and target “reasonably priced tech” – players with more reasonable valuations, i.e. companies whose price has fallen by at least 20 %, whose forward P/E ratio is below 25 and whose earnings growth remains well oriented.