Traders Don't Care About The Tech Surge Driving Valuations To Extremes

Wall Street speculators are disregarding warning indications that the technology market rise is overdone.

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Optimism that the Federal Reserve will reverse its most aggressive interest-rate hike cycle in four decades, which was a big negative for the industry last year, has driven the S&P 500 Information Technology Index up 19% in 2023, compared to the S&P 500 Index's 7.7% gain. According to Bloomberg statistics, this is the best start to a year for information technology since 2009. Last month, the sector outperformed the wider index by the highest in two decades. 

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However, one valuation model indicates that the excitement has gone too far. 

The S&P 500's technology firms are selling at about 25 times the expected profits. According to Bloomberg Intelligence statistics, the Fed would need to decrease rates by at least 300 basis points to justify such a multiple. This is more than five times what the swaps market is pricing in for interest rate reduction this year. 

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"Traders are betting on a significant shift in the Fed's interest-rate policy, but there is no guarantee as to whether or not this will occur," said Quincy Krosby, chief global strategist at LPL Financial. "The sector's long-term growth prospects are appealing, but not at these current valuations." 

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A poor earnings outlook for technology firms adds to the mistrust. According to Trade Algo, analysts estimate the sector's first-quarter profits to fall 15%, the third-largest drop among the S&P 500's 11 business groups.

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The prospect that the Fed is close to halting its rate rises has buoyed tech bulls, propelling S&P 500 tech stocks to their highest first quarter since 1998. A large portion of those gains occurred in March when turmoil in the US financial sector drove traders to cash-rich tech stocks in search of safety. 

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Apple Inc., Microsoft Corp., Nvidia Corp., Meta Platforms Inc., and Amazon.com Inc., collectively known as megacap high-fliers, have accounted for two-thirds of the S&P 500's gain this year. Microsoft is expected to release earnings this week. 

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Options traders, on the other hand, are less bullish than equity investors. The cost of contracts in the Invesco QQQ Trust, the largest exchange-traded fund tracking the Nasdaq 100 Index, that protect against a 10% loss is now 1.7 times higher than the cost of options that profit from a 10% rebound. According to Bloomberg data, this is the most in a year.

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JPMorgan Chase & Co. and Morgan Stanley strategists concur with options traders that the tech boom is unsustainable. 

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Since the Fed began raising rates in March 2022, technology stocks have been on a wild journey, falling for most of last year and then strongly rebounding to start this one. Last month, Fed officials raised interest rates by a quarter percentage point, raising their policy goal range to 4.75% to 5%. Swaps linked to the Fed forecast 57 basis point cuts this year, bringing the policy rate down from a peak of 5.12% in June to 4.55% in December. 

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Of course, none of this is set in stone, especially with inflation still considerably above the Fed's objective. Rate decreases, according to Wells Fargo Investment Institute and BNP Paribas SA strategists, will not occur until early 2024.

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"This Fed desperately wants to avoid compounding their initial error of labeling inflation transitory by prematurely declaring it dead," Sameer Samana, senior global market strategist at Wells Fargo Investment Institute, wrote in an email. "If anything, they may remain too hawkish for too long, rather than quickly pivoting to cuts." That is a market risk that is overlooked."

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However, history suggests that there may be more upside to come. According to Strategas Securities statistics, tech companies have achieved an average annualized return of 21% over the previous four rate-hiking cycles dating back to the mid-1990s. So far in this rate-hiking cycle, the S&P 500 Information Technology Index has gained only 1% and has been outperformed by numerous other industries. 

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"Investors now see current hikes as nearing an end after a very aggressive hiking cycle," Todd Sohn, managing director of technical strategy at Strategas, said. "That has contributed to this year's rally in technology shares."

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