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Heard on the Street Blog

Are Tech Stocks Living in a 2nd Dot-Com Bubble?

Over the past decade, investors have had an infatuation with large-cap tech stocks. Over the past 7 days, the Nasdaq reached a new all-time high of 11,126. This is up almost 68% since the lows in March, less than 5 month ago. This is despite being in the midst of a global pandemic that has seen the largest unemployment rate and largest drop in GDP since the Great Depression.

There are some other very stark similarities between the dot-com bubble and the current valuations some stocks are trading at. While we are not saying that we are necessarily in the midst of a second dot-com bubble, we think some of these technology valuations may be cause for concern and something that every investor should look into.

Valuations: The tech-heavy NASDAQ hit a new record of 11,126 last week and now has a current price-to-earnings ratio of 38.2. This is higher than peak P/E ratio in 2001, shortly after the internet bubble had burst. The tech sector's current outperformance of the broader market has also reached its highest level since July, 2000, which is another stark reminder of that era.

Crowding: A close look at market indices shows that investors have crowded into just a handful of tech leaders. Indeed, just six stocks account for 23% of the value of the S&P 500 index, which comprises stocks with the largest market capitalization—the value of a company defined as shares outstanding multiplied by its stock price. Another example of how narrow the market has become: When the S&P 500 pulled back 5% in June, an equal-weighted version of that index declined more than 11%, suggesting that the big tech names were supporting the broader index. Crowding is a risk because it may mean that even a relatively minor negative news event for a tech leader could trigger a sell-off and a sharper-than-expected downdraft for the broader market.

Margin Pressure: When a company’s costs rise, its profit margins can dip, even if sales continue at an increasing rate. Large-cap tech stocks could face increasing margin pressure, amid macroeconomic trends, such as deglobalization, a weaker U.S. dollar and scrutiny of low corporate tax rates. An estimated 58% of tech sector sales originate outside the U.S., where profit-margin advantages, such as lower labor and input costs, have been amplified by the purchasing power of the dollar, which hit a 20-year high, on a trade-weighted basis, over the past business cycle. We, at Cullen Investment Group, expect the dollar to weaken, even as U.S. corporations face more pressure to grow their domestic production, likely resulting in lower profit margins.

To be sure, the narrative around the digitalization of the global economy remains compelling for investors. Many understandably have sought the shelter of the tech favorites, which are household names—all the more so given the recent resurgence of COVID-19 cases in parts of the U.S. as well as the Federal Reserve’s cautious guidance on the path of economic recovery.

But we suggest paying close attention to growing signals of an unsustainable tech rally. Consider reducing tech exposure by adding to other sectors, such as financials, industrials, materials or a lagging consumer discretionary .

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