Morgan Stanley
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Tech Stocks Face Rising Risks

As the tech-heavy Nasdaq reaches new highs, the large-cap tech leaders of the past decade could be increasingly vulnerable.

Investors’ love affair with large-cap tech stocks is still going strong after 11 years. In fact, the Nasdaq Composite Index recently reached a new high, propelled by a handful of familiar consumer-facing tech companies that dominate the digital landscape, especially during this pandemic.

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Investors may be feeling TINA, the popular acronym for “there is no alternative” used to describe current market conditions. But I worry they may be ignoring increasing risks. Here are the three to consider:

  • Valuations: The tech-heavy Nasdaq hit a record 10017 the last week in June and now sports a price-to-earnings ratio of 37.2. That’s higher than the peak 35.8 PE ratio in 2001, soon after the Internet bubble burst. The tech sector’s current outperformance relative to the broader market also reached its highest level since July, 2000, another echo of that era.
  • Crowding: A close look at market indices shows that investors have crowded into a handful of tech leaders. Indeed, 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 apace. 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 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 stalwart tech favorites—all the more so given the recent resurgence of COVID-19 cases in parts of the U.S. and the Federal Reserve’s cautious guidance on the path of economic recovery.

But I suggest paying attention to growing signs of an unsustainable tech rally. Consider reducing tech exposure by adding to other sectors, such as financials, industrials or materials.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from June 29, 2020, “Tech Tonic.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.