Are technology stocks expensive?

A common question we receive from clients and prospective clients is how long can technology stocks (Nasdaq 100) continue to propel the current bull market? A familiar theme in my editorials is earnings drive stock prices. In the short term, many factors have a significant impact on the stock market – geopolitical events such as the U.S. / Iran war, commodity prices, regulatory changes, interest rates, etc. However, the single largest factor influencing the long-term trajectory of stocks is earnings. Earnings aren’t everything when it comes to investing in the stock market, but they are, by far, the largest factor to consider. Another significant factor influencing stock prices is valuation, which is often expressed as the Price-to-Earnings (P/E) multiple. The P/E multiple is the best-known measure of valuation but isn’t the only measure. Other common stock market valuation measures include Price-to-Book Value, Price-to-Cash Flow, Price-to-EBITDA, etc.

If the price of a stock increases without growth in the company’s earnings, that stock has experienced what is known as ‘multiple expansion’. Mathematically, the numerator ‘P’ has increased while the denominator ‘E’ remained constant. For example, if a stock’s price has increased from $40 to $50 while the earnings of that company remained static at $5 per share, that stock’s P/E ratio has expanded from eight (40/5) to ten (50/5). The opposite can also occur, known as ‘multiple compression’. Multiple expansion and compression happen daily in the market driven by expectations surrounding earnings growth, regulatory changes, interest rate changes, demographic changes, etc. The most significant market returns are typically earned by investing in stocks which experience growth in earnings as well as multiple expansion. Conversely, the largest losses typically occur in stocks where earnings are declining while multiples compress. Stated another way, one could invest in a stock which is able to grow its earnings and lose money if the multiple on that stock contracts – correctly predicted earnings growth but didn’t consider how expensive the stock was.

The relative and absolute valuation of stocks has an impact on expected returns. If the P/E multiple is extremely high, future earnings growth may have already been discounted (priced into the stock), meaning that even if the company is able to grow its earnings, the stock price may not increase. This week’s chart is interesting because it highlights that while technology stocks (Nasdaq 100) continue to lead the market higher (red line), the relative valuation of technology stocks (blue line; Nasdaq 100 vs. S&P 500) is the lowest it’s been since 2017. This means technology stocks have been experiencing multiple compression (earnings growth has exceeded share price increases). I would be more concerned if we saw the opposite, or multiple expansion in technology stocks. Technology stocks are the cheapest they’ve been since 2017 even with most trading at or near all-time highs. If technology stocks can continue to grow earnings at a faster pace than the broader stock market (S&P 500), there’s no reason technology stocks can’t continue to lead this bull market.