NASDAQ a runaway performer
The tech-heavy NASDAQ is up 13% YTD, outpacing S&P 500 by over 15pp, and leading to unfavorable parallels with the tech bubble, which burst on March 10, 2000. We believe a lot has changed since then, making a continued tech rally sustainable. Valuations are a lot lower than then, growth similar, profitability higher, tech adoption more developed, and with few signs of tech IPO and fund flows excess. We remain overweight the IT sector, focused on software and semis.
The NASDAQ outperformance has accelerated the last decade, as ‘tech’ adoption and disruption has spread. The thirty-year (1990-2020) return CAGR for tech-heavy NASDAQ is 10.9% vs 7.5% for broad-based S&P 500, and 7.2% for industrial-heavy Dow Jones. We think outperformance can continue.
How NASDAQ is different today
….heavily concentrated index
The NASDAQ (COMP) index was founded in 1971. It is a market cap weighted index comprising all NASDAQ listed stocks. The number of stocks has declined near in half from a pre-tech bubble 5,000 to 2,700 currently. Index concentration has always been high, with the top 10 stocks making up c65% of the index at the time of the2000 tech bubble vs c75% today.
…but ‘only’ half is IT
The IT sector makes up 53% of the NASDAQ index today, the highest level since 2002, but still well-short of the 73% ‘tech bubble’ peak. It also represents only 390 companies amongst the total c2,700 NASDAQ constituents, with the bulk of the rest in the consumer services, healthcare, and financials sectors. By contrast the IT weight in the S&P 500 is 26%.
Only two of top-10 NASDAQ stocks from the 2000 tech bubble are as relevant today as then, Microsoft (MSFT) and Intel (INTC). Whilst these top 10 largest stocks have market caps three times as large today as they did twenty years ago (see table below), and the list is also broader by segment, reflecting the development of the tech space, and now includes social media, e-commerce, payments, and streaming companies.
Four reasons not to be concerned by rally
- Valuation premium in-line, and lot less than 2000
The NASDAQ has historically been expensive vs S&P. The current 32.3x vs 23.5x P/E compares to an all- time high NASDAQ P/E of 72x in 2000, more than double the S&P 500 valuation then. The current 40% P/E premium is also only modestly above the long-term average 28% premium to the S&P 500.
2. Showing relative earnings resilience
NASDAQ earnings growth has also been somewhat higher over time than for the S&P 500, and is now being more resilient. Consensus NASDAQ EPS growth expectations for 2020 are for 0% growth, down <10pp from the January 1 level, and compared to the S&P 500 outlook for -22% growth, down from January 1 +10% earnings growth.
3. IPO and flows sentiment indicators muted
Other sentiment indicators, such as IPO activity and fund flows, are likewise not at extreme levels in our view:
- IPOs: There were 87 global IT sector IPO’s YTD, 21% of the total, and the number broadly in line with those seen in healthcare and industrials. In the US, there were many more healthcare IPO’s than IT this year.
- Fund Flows: US tech has seen US$9.1bn combined mutual fund + ETF inflows YTD, according to Lipper. This is equal to 4% of total fund assets, making it only the proportional 5th sector highest of the 11 main sectors.
The growth and profitability contours of the largest NASDAQ stocks are remarkably unchanged over the years, with high margins and profitability, strong growth, and relatively low leverage (above chart). As shown above vs 2000, sales growth is now lower and leverage higher, but profitability and EPS growth higher.
Additionally, supporting this is the levels of tech adoption and disruption are significantly greater today, but also with plenty of room for growth. Global broadband penetration is around 15%, social media penetration 45%, and internet penetration 57%.
What to own: Software and Semis vs Hardware
Our allocation framework helps identify relative buy and sell signals for sectors and industries by comparing market sentiment versus fundamentals, with a valuation overlay (see table below for methodology details). The more out of favor, with better relative industry fundamentals, the better.
We are overweight the broad US tech sector, proxied by the US$33bn asset Technology Select Sector SPDR ETF (XLK). Microsoft (MSFT) and Apple (AAPL) are the two largest holdings, at a combined 41% weight.
Software and Semiconductors sit firmly in the top right ‘momentum’ framework quadrant, well-liked by the market, but with above average fundamentals that is more than supporting the premium valuation. We are overweight both segments. Semis is proxied by the Invesco Dynamic Semiconductors ETF (PSI), with Nvidia (NVDA) and Advanced Micro Devices (AMD) the top two holdings, 115 of total. Software is proxied by the Invesco Dynamic Software ETF (PSJ), with Synopsys (SNPS) and Activision Blizzard (ATVI) the two largest holdings, with an 11% weight.
By contrast, tech hardware is in the less-favorable bottom-right ‘sell’ quadrant, well-liked by the market but with negative relative fundamentals. We are neutral the tech hardware segment, with the poorer relative fundamentals balanced by the cheaper valuation. US tech hardware is proxied by the SPDR S&P Technology Hardware ETF (XTH).
We see two equally balanced main risks to continued tech and NASDAQ outperformance, a faster than expected recovery driving a rotation to value, or stepped up regulatory scrutiny of select mega-cap tech names.
- Value rotation. A faster than expected economic recovery, and higher bond yields, could drive a rotation out of quality growth sectors, such as tech, into cheaper, more cyclical, and out-of-favor value sectors such as financials or energy. We analyzed this in our June 26th note: Value down not out
- Regulatory risk. An alternative risk is broader regulation against US tech mega-caps. Given the high index concentration this would only need to hobble a few of them to make a significant difference. Though we have argued that if anything tech regulatory risks are falling rather than rising. See our April 27th note: FAANGMs foundation of this market
Conclusion: NASDAQ twenty years on
The tech-heavy NASDAQ is up 13% this year, and continues to significantly outperform, drawing unfavorable parallels with the tech bubble of 20 years ago. A lot has changed since then, for better and for worse. The index is now more concentrated, and with half the number of stocks, and only two of tech bubble top-10 are still there (MSFT and INTC). But it is now less tech-heavy (50%), a lot cheaper (<half P/E), with similar growth and higher profitability, and tech adoption is now an accelerating reality. Measures of exuberance, such as IPO’s and fund flows, are still relatively restrained. We are overweight the US IT sector, focused on software and semiconductors.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.