Is Big Tech as Cheap as It Seems? Maybe, Maybe Not…

May 27, 2022

If you have been following the financial news at all this year, you’ve likely heard about the historic declines in large-cap technology stocks.

For example, the Nasdaq 100 Index (NDX) — a proxy for “big tech” that includes the roughly 100 largest non-financial stocks that trade on the Nasdaq Stock Market — has fallen as much as 31% from its recent highs last fall.

The popular “FAANG” stocks — which include Facebook parent company Meta (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Google parent Alphabet (GOOG) — have fallen an average of 48% over the same period.

And several other well-known tech stocks have fallen even further.

As a result, many of these companies are trading at their lowest prices in years, leading many investors to wonder if it’s time to “back up the truck” and aggressively buy shares today.

Unfortunately, the answer isn’t necessarily as clear-cut as you might assume.

Fact No. 1: Big Tech Is On Sale for the First Time in Years

The Nasdaq 100’s forward price-to-earnings (P/E) ratio — which is based on analysts’ earnings estimates for the current fiscal year — has been cut in half from well over 40 in 2020 to the low 20s today. For comparison, the S&P 500’s forward P/E fell from near 30 to 18 over the same period.

That means big tech stocks aren’t just cheaper on an absolute basis. They’re also trading at the smallest markup (or “premium”) to the overall market we’ve seen since the March 2020 lows.

The recent declines have also pushed the Nasdaq 100’s year-over-year returns into negative territory.

As TradeSmith Senior Analyst Mike Burnick noted earlier this month, this is relatively rare. In fact, it has only happened four other times since the 2008-2009 financial crisis: in 2011, 2016, 2019, and 2020. And each of those declines in the Nasdaq 100 were followed by sharp rebounds over the next 12 months, ranging from 31% (2011) to as much as 105% (2020).

In other words, if the markets continue to behave as they have over the past decade or so, the data suggests big tech stocks are a screaming buy today.

However, there are also some reasons for caution.

While the magnitude of the recent decline in the Nasdaq 100 was on par with those four previous extremes, there are a couple of notable differences this time around.

Fact No. 2: This Decline Started from Nosebleed Valuations

As I mentioned earlier, the Nasdaq 100’s forward P/E ratio fell from above 40 to the low 20s today. That’s a big decline.

However, it’s important to understand that P/E above 40 was higher than any we’ve seen since the peak of the dot-com bubble in the early 2000s. As a result, this big decline has only brought the index’s P/E ratio back down to around its long-term average.

The following chart from Bloomberg puts this move in perspective.

(Note: This chart references the Nasdaq Composite rather than the Nasdaq 100. This index includes a similar weighting to large-cap technology stocks as the Nasdaq 100. However, it also includes small relative weightings toward all the remaining smaller stocks that trade exclusively on the Nasdaq exchange. As a result, this index tends to trade at a slightly different valuation than the Nasdaq 100.)

As you can see, technology stocks were significantly cheaper at three of the previous four major lows in 2011, 2016, and 2019. The 2020 low occurred at a similar valuation as today.

Why is this important?

Because it means big tech would have to decline another 20% to 40% from here to reach those prior levels.

This scenario assumes that current earnings estimates are correct.

But given the Federal Reserve’s aggressive tightening plans to fight inflation, that isn’t necessarily the case.

It’s quite possible the U.S. economy could dip into a recession in the months ahead. If it does, earnings are likely to fall significantly, and stocks would have to fall even further to reach those lows.

This risk appears similar when we compare big tech versus the overall market.

Today, tech stocks trade at around 1.4 times the valuation of the S&P 500. That’s down from a peak of around 1.6 in late 2020.

However, as you can see in this next chart, tech stocks traded at significantly lower premiums versus the S&P 500 at all four of the previous lows, including March 2020.

This chart implies tech stocks would have to fall 20% or more versus the S&P 500 to reach those prior lows. And again, this assumes the overall market doesn’t become cheaper in the meantime. If it does, then the downside in tech stocks could be even greater.

Fact No. 3: The Fed Put Is No More

The other important difference between now and the previous significant Nasdaq 100 declines has to do with the Federal Reserve.

Since the early 1990s, the market has operated under the growing assumption that the Fed would step in with easy money policies whenever the markets or economy hit a rough patch.

This came to be known as the “Fed put,” because investors believed it provided “insurance” against a broad market crash, like buying a put option on stocks.

Now, you could argue that the Fed put hasn’t really worked as described. It didn’t prevent the market from plunging 20% or more multiple times over the past few decades, including two multiyear bear markets from 2000 to 2003 and 2007 to 2009.

However, it does seem to have had a major impact on stock market valuations. The next chart shows what I mean.

As you can see, over the past 150 years or so, the mean P/E ratio for the overall market has been around 16.

For most of that time, the market has tended to trade at roughly half that level (P/E of 8 to 10) at major lows (highlighted by the red circle). However, since the Fed put started, the market has rarely traded for less than the mean at major lows.

In other words, the Fed put appears to have put a “floor” under stock market valuations. And that seems to be particularly true over the past 10 years.

However, that may no longer be the case.

As I mentioned before, the Fed is now tightening monetary policy to fight inflation. However, for the first time in decades, it is promising to continue even if it means hurting the stock market.

Without the Fed put, the broad market could fall to significantly lower valuations than we’ve seen in a long, long time. And if it does, big tech valuations could fall much further, too.

The Bottom Line

Big tech stocks are the cheapest they’ve been in years and could be poised for a rebound in the months ahead. However, they aren’t yet truly “cheap” on a historical basis, and the downside risk could be greater than it has been recently.

So, if you’re itching to get back into these stocks, I think it’s fine to start looking around. However, I would urge you to be patient and selective.

For example, while the Nasdaq 100 isn’t historically cheap, some of its individual stocks are starting to look like real bargains today.

GOOG, FB, and NFLX are all trading at forward P/Es of 18 or less. That’s in line with the overall market, and lower than the valuations of many blue chips today. And by some measures, these stocks are even cheaper than the P/Es would indicate.

Of course, that doesn’t mean these stocks can’t fall further, especially if earnings weaken in the months ahead. But these are levels that are compelling for investors with a long-term horizon.

That said, most of these stocks are still in the TradeSmith Health Indicator Red Zone today. So I don’t think there’s any need to hurry or get too aggressive unless that changes or the sector as a whole becomes too cheap to ignore.

The best buying opportunities could still be ahead.