Goldman Sachs warns of high tech valuations
The tech sector is particularly interesting to investors because it’s a high-growth industry that’s driven by innovation. Tech stocks generally outperform the market. Tech ETFs have also gained significant value over the years. The Invesco QQQ Trust, Series 1 ETF (QQQ) has returned 111.0% in the last five years. In comparison, the Technology Select Sector SPDR ETF (XLK) is up 124.0%, while the VanEck Vectors Semiconductor ETF (SMH) is up 137.0% in the same period.
But there’s one drawback to investing in technology: these stocks have high betas, which suggests they’ll also fall faster than the overall market in the event of a bear run. The stock market carnage back in 2001 was driven by overvalued tech stocks. Will history repeat itself, or is there still some leeway for upside potential? According to investment bank Goldman Sachs (GS), tech stocks’ valuations are sky-high.
Software stocks are trading at a premium
Tech stocks have been Wall Street’s darlings for several years. Several companies across the semiconductor, software, and gaming spaces have seen their stock prices skyrocket over the years. Now, Goldman Sachs believes these stocks are overvalued. The bank has outlined software stocks as especially risky at current prices. Software stocks have high profit margins and are somewhat insulated from the ongoing trade war, which has driven investor optimism, leading to premium valuations.
Goldman’s chief equity strategist, David Kostin, said, “Rising market concentration and the political landscape suggest that regulatory risk will persist and could eventually weigh on company fundamentals. The valuation premium for growth is elevated today relative to history; Software in particular now carries the highest multiples since the Tech Bubble.”
Goldman has advised clients to limit their exposure to companies that can be slammed with antitrust lawsuits. It’s also claimed that tech stocks carry “a valuation premium two standard deviations above [the] 10-year average across a range of metrics.”
Software companies have the highest multiples within the tech industry. According to Kostin, the companies with the highest enterprise value-to-sales multiples underperform in the long run.
The US semiconductor industry has high exposure to China and will continue to be affected by the ongoing trade war. The upcoming earnings season will be the next driver for tech stocks. However, data for the second quarter doesn’t look optimistic. A FactSet reports states that out of 113 S&P 500 companies that have issued earnings guidances for the second quarter, 87 have issued negative outlooks.
In the tech space, 26 companies have issued negative earnings guidances, which is higher than the five-year average of 20.4. Semiconductor companies will lead this decline, with nine companies expecting negative earnings as the downcycle continues to affect sales.
Another report states that companies with higher international exposure will be negatively affected in the second quarter, indicating that the global market environment is sluggish. Further, big tech companies such as Apple, Facebook, and Google have been hit by privacy regulations recently, making investors wary.
Growth hasn’t stopped in software
While Goldman is cautious about overvalued software stocks, several of these stocks are supported by high growth metrics. Companies such as ServiceNow (NOW), Adobe (ADBE), Splunk (SPLK), and Workday are still growing their sales and bottom lines at a robust pace.
So how do investors play this market? They’ll need to focus on individual stocks that have high growth metrics and are trading at reasonable valuations rather than ETFs with exposure to a basket of stocks.