Reversion to the mean?
Will tech stocks cool after torrid first-half surge?
Bottom Line
Technology stocks have enjoyed their best first half in 40 years. The NASDAQ Composite has surged 31.9% on a price-only basis since the beginning of the year, its strongest start to a new year since it soared 37.8% in the first half of 1983. The S&P 500 is no slouch, rising by 16% on a price-only basis thus far in 2023, as tech stocks have pulled the broader index along with it.
What’s driving the rally? Enthusiasm for exciting artificial intelligence (AI) potential is off the charts, spurring a significant Fear of Missing Out (FOMO) among investors. But is this enthusiasm sustainable? Perhaps valuations have gotten a tad frothy, as we saw in the late 1990s in the run up into the Y2K calendar changeover.
‘Big Eight’ tech stocks leading the charge There’s been a significant divergence in the first half of this year between the performance of eight large technology stocks and the rest of the S&P 500. The combination of Apple, Microsoft, Alphabet (Google), Amazon, Nvidia, Tesla, Meta (Facebook) and Netflix account for 28.2% of the current weight in the index, and they have soared 58.6% in this year’s first half. But when we strip them out, the remaining 492 stocks in the S&P have collectively risen by a more pedestrian 2.8%.
Reversion to the mean? The 200-day moving average for the NASDAQ Composite is about 16% below current index prices, while the S&P’s 200-day moving average is about 10% below current prices. By comparison, when the technology bubble burst in March 2000 (due to a 90% fourth-quarter surge in 1999), the NASDAQ peaked nearly 59% above its 200-day moving average while the S&P peaked about 11% above its 200-day moving average. So, while overbought in our view, technology stocks today are not nearly as extended as they were in 2000.
What about valuation fundamentals? Nvidia is the poster child of the AI/FOMO feeding frenzy that has fueled this “Big Eight” technology rally. From the equity market’s bottom in mid-October 2022, it has more than quadrupled in price to a record $440 and is trading 50% above its 200-day moving average. The stock is valued at 44 times this year’s estimated revenues per share and at 132 times this year’s estimated earnings per share.
Second quarter earnings If enthusiasm for AI fails to adequately materialize in a tech company’s revenues and earnings, we could experience at least a temporary correction in share prices, thus returning stocks to more reasonable valuation levels. The second-quarter earnings season will start in earnest in a fortnight.
According to FactSet, S&P revenues in the second quarter of 2023 are expected to decline by a modest 0.4% year-over-year (y/y). That’s down from an increase of 3.8% in the first quarter of 2023 and a 13.3% y/y increase in the second quarter of 2022. This would mark the S&P’s first y/y decline in revenues since the 1.1% drop in the third quarter of 2020.
S&P earnings in the second quarter of 2023 are expected to decline 6.8% y/y, worse than the decline of 3.9% in the first quarter and a 7.4% y/y increase in the second quarter of 2022. This would mark the largest earnings decline since the pandemic-fueled 31.6% y/y decline in the second quarter of 2020. About 23% of S&P 500 companies have issued earnings guidance on their prospective second-quarter results in recent weeks, and negative guidance has outnumbered positive 1.5-to-1. Profit margins are expected to decline for the sixth consecutive quarter.
Economy slowing Over the past three quarters, GDP growth here in the U.S. has decelerated from a gain of 3.2% in the third quarter of 2022 to 2.6% in the fourth quarter and 2% in this year’s first quarter. That’s a trend we expect to continue, culminating in our forecast for a pair of negative GDP prints in the back half of this year.
Fed hawkish due to sticky core inflation This morning, we learned that the nominal Personal Consumption Expenditures (PCE) index declined from a 41-year peak of 7% in June 2022 to 3.8% in May 2023, marking an impressive decline of 3.2% over the past 11 months. But the core PCE (the Fed’s preferred measure of inflation) has only declined from a 39-year peak of 5.4% in February 2022 to 4.6% in May 2023.
The Fed’s target for this metric remains at 2%, and in their June SEP, policymakers forecast core PCE inflation to reach only 2.2% by year-end 2025. As a result, they are likely to add another two quarter-point interest rate hikes in this year’s second half before pausing. We expect them to remain on the sidelines before beginning to cut interest rates sometime in 2024.
Labor market weakens and consumer spending eases As a result of the Fed’s tighter monetary policy, the labor market and consumer spending have both considerably weakened during the first half of this year. We expect this trend to continue over the balance of this year. At 265,000, initial weekly jobless claims for the June nonfarm survey week have risen 37% over the past five months to the highest level since October 2021. Retail sales during the March/April Easter season rose a tepid 1.7% y/y, a bad omen for the important back-to-school and Christmas shopping seasons. With today’s Supreme Court ruling that the Biden administration’s plan to forgive student loan debt is unconstitutional, the resumption of monthly payments in August should further pressure consumer spending.
Is a recession looming next year? There are several historically accurate leading indicators that concern us. The Leading Economic Indicators (LEI) have now been negative 14 consecutive months. The ISM Manufacturing Index has been below the critical 50 contraction level seven months in a row. And three of the bond markets key yield curve relationships are significantly inverted by more than 100 basis points: fed funds to 10-year Treasuries, two-year to 10-year Treasuries and three-month to 10-year Treasuries.
From worst to first? The S&P has performed extraordinarily well so far this year and since the equity market’s bottom last October, with growth stocks crushing value. But with technology stocks extended due to AI FOMO, a potentially challenging second-quarter earnings season and deteriorating macroeconomic fundamentals could have investors locking in their tech profits and rotating into cheaper, potentially higher-yielding defensive stocks.