How Overbought, Overvalued Are The Top Tech Stocks? Not As Much As You Might Think

|
Includes: AAPL, AMZN, FB, GOOG, GOOGL, IYW, MSFT, NFLX
by: James Brumley

Summary

FANG stocks and big tech have carried most of the weight for the broad market's recent rally.

More than a few observers are now saying tech's in a bubble that's about to burst.

A look at key fundamental metrics says the top tech names mostly deserve their big gains.

The iShares Dow Jones US Technology ETF (NYSEARCA:IYW) is up a healthy 21% since the end of last year, handily topping the 8.9% gain the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) has mustered for the same timeframe. The disparity widens when you stretch the timeframe considered. Since this date on the calendar last year, the technology ETF is up a whopping 39%, trouncing the Spyder's 17.8% gain for the same timeframe.


Source: TradeNavigator

It's certainly been a fun ride for those overweighted in technology stocks, and names like Amazon (NASDAQ:AMZN) and Apple (NASDAQ:AAPL) in particular. The so-called "FANG" stocks have done most of the market's heavy lifting this year so far.

The big rally has more than a few investors worried, though, that technology stocks as a whole are in a bubble that's about to pop, as valuation realities start to kick in.

As it turns out, those pessimists are only half right.

The data doesn't exist for the iShares Dow Jones US Technology ETF. But the numbers are available for the S&P 500 Technology Index. Those numbers are plotted on the images below, which graph the index's earnings history and projections, as well as plot the trailing and projected P/E. As it stands right now, the index is valued at a trailing price/earnings value of 22.75, and a forward-looking (12-month) P/E of 18.8. The former is above the norm, but the latter isn't. The pink arrows mark the data as of the end of the first quarter.


Source: Data from Standard & Poor's, image made by author with TradeStation

Note the Q1's earnings comparison for the S&P 500 Technology Index marked impressive growth. Granted, the bar was low - the first quarter of 2016 was rather disappointing. Also note, however, that as of the first quarter's numbers the industry's net earnings are back on a bullish trajectory after stalling for the better part of 2015 and 2016.

It's not simple accounting tricks or buybacks doing this work either. Last quarter's as well as the fourth quarter's revenue were both up on a year-over-year basis, as were net margins. In fact, both margins and sales for Q4 and then Q1 were the highest Q4 and Q1 metrics we've seen during this economic expansion cycle.


Source: Data from Standard & Poor's, image made by author with TradeStation

To the extent it matters (and it will in just a moment), the S&P 500 Technology Index's trailing price/sales ratio stands at 4.28... higher than the market's average, but not at all unusual for the tech sector.

All those figures jibe with the available data for the iShares Dow Jones US Technology ETF.

Be that as it may, the fact that only a handful of the market's top technology names have uncomfortably outperformed the tech sector itself - let alone the broad market - is concerning. Big runups set up big-time profit taking, and many investors are concerned the bubble could burst at any minute.

The performance-comparison chart below tells the tale. The ETF's biggest holdings are the aforementioned Apple, Microsoft (NASDAQ:MSFT), Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) and Facebook (NASDAQ:FB); ditto for the S&P 500 Technology Index. With the exception of Microsoft, the ETF's biggest names have considerably outperformed IYW since the end of last year, forcing investors to consider the distinct possibility that the sector as a whole as well as its components are ripe for a reversal.


Source: TradeNavigator

Here's the inherent problem with that assumption... most of the FANG stocks and/or the tech sector's biggest names are more or less justifying their wild rallies of late.

OK, to be clear and fair, from nothing but a P/E perspective all the technology sector's top stocks are arguably overvalued. They've earned their premium valuations though. The tables below lay out all the relevant numbers. Pay close attention to the PEG ratios and earnings growth rates, which arguably do more for a stock's price than a P/E or P/S ratio alone.


Source: Thomson Reuters, table made by author

In some regards they've overvalued, but in many regards, they're actually undervalued. More important, on an all-encompassing performance basis it's not as if these biggest names and red-hot performers are any more overvalued than the sector as a whole is. They're collectively growing the bottom line better than their peers are.

The two outliers not listed are Amazon.com and Netflix (NASDAQ:NFLX). Both have atrocious performance metrics, and likely will for the foreseeable future. Both are still story stocks though, so traders are ignoring their tepid results on hopes that the future looks better than the past. For the purposes of a fundamental valuation of the sector as a whole, they're useless.

Bottom Line

As is always the case, there's more to this story. As nice as it would be to reduce the tech sector's biggest names down to mere numbers, that's not a good idea. The unquantifiable matters just as much in some cases, as in the case of Amazon and Netflix.

It's also worth noting that a reasonable, fair valuation for the technology stocks that have been doing most of the driving for the sector and technology ETFs like the iShares Dow Jones US Technology ETF can't alone stave off a corrective move. Such a move would be technical, more than a fundamental one though, and likely be relatively short lived.

More than anything, the key takeaway is an understanding that as much circulation that the tech-bubble story is getting, the fear-mongering portion of it isn't driven by fundamentals. These top-tier companies have largely earned their recent gains.

In other words, as incredible as it seems, any dip is a buying opportunity if you missed out on the first bullish wave.

One final thought on that matter... while valuation isn't really a problem right now, perception is. When and if these big tech names start to show short-term cracks, the profit-takers could and likely will come out of the woodwork in a panic. Don't be too quick to try and catch that falling knife, even if you're just waiting for the right time to get into iShares Technology ETF or a similar ETF. IYW would have to slide all the way back to a support level around $131.75 before finding any real floor. That's roughly a 10% pullback from its current level. FANG stocks and the like are even more vulnerable to some quick, albeit short-lived, selling.


Source: Schwab's StreetSmart Pro

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.