Laurent Denize, Global Co-CIO, ODDO BHF AM.
” The current situation differs from that observed in 1999, as the valuations of tech companies – far from being exuberant – are today justified by the strength of their economic fundamentals”
Large-cap growth stocks are once again driving the market, especially in the US where the “Magnificent Seven”, except for Tesla, dominate S&P 500 gains in 2024. US tech stocks continue to stand out, outperforming the S&P 500 by 7.4% since October 2023. With similar levels of outperformance, European technology stocks are also experiencing a good momentum. This rotation from defensive to technology stocks is accelerating, as investors bet on an environment of low inflation and modest growth. The recent resurgence of large-cap growth and technology stocks is reminiscent of 1999. Back then, these stocks were very expensive and offered unattractive risk/return ratios. Yet they continued to rise, with the Nasdaq 100 climbing 126% between 1 January 1999 and its peak in March 2000. It took a wave of interest rate rises and poor results from leading stocks such as Qualcomm to send the market tumbling.
The parallel with 1999 begs the question of whether we are currently in a similar bubble. A closer look reveals key differences:
The current valuations of most technology stocks are far from exuberant. Since the launch of ChatGPT, the S&P500 index has risen by 27% thanks to technology stocks while the same equal-weighted index is up only 11%. If the US tech sector looks expensive, there is certainly room for further price rises. The sector’s 12- month forward P/E ratio, now at 28.5, is still a long way from the peak of 48.3 recorded in April 2000. Despite rising bond yields, they remain well below the 6.8% reached in January 2000, making the equity risk premium much more generous than at the height of the tech bubble.
Even if the current rally is supported by only a few stocks, investors are favoring growth stocks which, unlike in 1999, have comfortable profit margins and low debt. These quality companies increase the likelihood that the trend will continue. Positive statements by the management of companies such as Nvidia and Alphabet, along with the strengthening of the “Momentum Factor*” (driven by quality), distinguish the current period from 1999.
The myth of unprofitability
Today, most technology stocks are profitable. Nvidia is a case in point. Its sales have reached USD 61 billion in 2023, double the figure of 2022, with earnings up 9- fold over 1 year to USD 12.3 billion. Attracted by this stellar performance, investors boosted Nvidia’s market capitalisation to USD 2,000 billion, an increase of almost 30% in February alone. The picture is similar for Microsoft and Alphabet.
Microsoft has been generating a constant EBITDA margin of 50% for the past five years. Estimated earnings growth of around 15% over the next two years makes the P/E ratio of 35x more appropriate. On this basis, all other things being equal, this ratio would fall to 30x by 2025 and to 26x by 2026.
What’s more, Microsoft has USD 81 billion in available cash. With short-term interest rates in the US at 5%, the return on cash is boosting its EPS. This cash offers opportunities for growth through acquisitions should organic growth falter. Finally, considerable market share currently provides high barriers to entry and an ability to adjust prices unrivalled among competitors. In fact, this is the ideal equation (in the short term at least) since it combines price and volume.
The myth of disenchantment
Technology stocks continue to attract inflows. According to a recent survey by JP Morgan which incorporates the strong start of the technology sector in the first two months, 56% of investors believe that the Magnificent Seven will continue to perform well in 2024. This positive sentiment is coupled with strong inflows into US indices. Over the last 5 weeks, the S&P 500 has seen USD 75 billion of inflows, not to mention continued flows into the Nasdaq.
The daily volume traded on Nvidia is USD 30 billion, or 10 times the total volume traded on the CAC40. Will this trend eventually go out of fashion? The polarization may seem extreme, but for the time being, it is justified by outstanding results accompanied by remarkable market performance.
The myth of a burst linked to a rate hike
Our central scenario does not involve a rise in interest rates likely to cause a sharp fall in technology stocks. In the 1990s, rising interest rates burst the internet bubble. Today, the markets are expecting interest rates to fall over the course of the year, underpinned by stabilized growth and disinflation. Even if growth eventually rekindles inflationary forces, the lagged nature of inflation means that prices could remain contained for most of 2024. This specific environment could easily fuel a new wave of speculative fever in technology stocks, especially given the resurgence of the “Momentum Factor*”. The scenario in which the Fed does not cut rates would be much less positive, with growth stronger than expected and inflation more resilient. Is this so unfavorable? Not so much, because the upward revision of growth would lead to a rise in EPS, which would more than offset the rise in long-term interest rates, especially if margins remain at these levels.
The myth of an imminent reversal in earnings
We do not believe an earnings trend reversal will materialize in the short to medium term. To anticipate a rapid turnaround remains challenging though. Take the semiconductors industry for example: companies such as ASML are forecasting earnings growth of 30% over the next 2 to 3 years, driven by a renewal of the next-generation chip infrastructure.
The myth of a rotation towards “Value” sectors
Mean reversion towards Value stocks, driven by profit-taking on high valuations, seems unlikely to us. For such a move to take place, economic growth would need to accelerate, triggered by a rise in industrial output. In the absence of a fiscal stimulus, this is unlikely to happen without a significant recovery in China, which is still grappling with the lingering effects of its Real Estate crisis.
In summary, the current situation differs from that observed in 1999, as the valuations of tech companies – far from being exuberant – are today justified by the strength of their economic fundamentals.
How should investors position themselves?
On Equities, the recommended strategy remains focused on Artificial Intelligence, Luxury Goods and Healthcare.
On Rates, the prospect of disinflation and moderate growth should enable the Fed to cut rates. By 50, 75 or 100bps isn’t really the point. What matters more is initiating the move. In this respect, we are taking full profits on the flattening of the 2/10-year curve and partial profits on the 10/30-year curve. We are buying 5-year bonds and selling 10-year bonds. Finally, we are increasing our duration on the US 10-year government bond. The risk of a 20-30bps rise is offset by the carry. We need to think long-term. At 4.50% on US sovereign yields, we are close to the “fair price” (2% potential growth and 2.50% structural inflation).
On Credit, we are looking at 300bps on High Yield before taking profit. Is it worth taking the risk of a reversal in markets for a potential 50bps tightening? In our view, yes. This is reinforced by the fundamental advantage of credit: carry.
