3 Reasons Why Tech Stocks May Have Topped

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By: R. Scott Raynovich

Have tech stocks topped for the year? The technology markets are showing signs of fatigue. Something doesn't feel right when the Nasdaq has rallied 20% year-to-date in the face of increased tensions of a trade war, many major semiconductor stocks such as Nvidia are well off the highs, and large, unprofitable Initial Public Offerings (IPOs) such as Uber being foisted upon the market, only to fail. 

What gives? Valuations are high, even though growth is slowing. Red flags abound. This doesn't mean I'm pessimistic about technology. It will be the place to invest for the next 100 years. It just looks like markets have become overvalued on many metrics, and the IPO market in particular is concerning.

Here are three reasons I think we may have a major correction in store over the next 6-12 months.

1) Valuations Are Too High

Stocks are valued on their future earnings potential. The higher the valuation relative to profits or sales, the more positive expectations are built in. Right now, the trendiest cloud technology stocks have almost absurd expectations built into them. Everything would have to be perfect from here on out.

On a price/earnings basis, the overall stock market is high. For example, according to this analysis by Advisor Perspectives, the recent trailing twelve months price/earnings ratio was at 21.7. The long-term average is 16.8. The PE10 ratio, which smooths earnings over 10 years to correct for volatility, was recently 30 -- that is 113% above a 150-year regression trendline. The historical PE10 ratio is around 17. 

As Advisor Perspectives concludes: "Relative to the mean, the market remains quite expensive, with the ratio approximately 78% above its arithmetic mean and 92% above its geometric mean."

In tech land it's worse. If you look at certain fashionable technology stocks, their valuations have become even more egregious on a price/sales ratio. Let's just look at the worst offenders on a price/sales ratio basis:

Atlassian (TEAM): 27X sales 
Twilio (TWLO): 24X
Verisign (VRSN): 19X
Hubspot (HUBS): 15X
Adobe (ADBE): 14X
RingCentral (RNG): 14X
New Relic (NEWR): 13X
Qualys (QLYS): 12X
Spunk (SPLK) 12X

In technology, the average price/sales ratio historically has been about 2X sales, according to Factset research. At peaks the average has crept as high as 8. And high-growing companies tend to trade at higher P/S ratios. But as a personal rule, a P/S ratio over 10 has historically been very risky, no matter how high the growth rate. In the end, it's very difficult to sustain these types of valuations. A company with a P/S of 10 would have to double sales every year for three years to "grow" into a more normal P/S valuation of 2.5X sales. 

At the same time that valuations have crept up, earnings have actually decreased in the past year. According to research firm CSI, the P/S ratio of tech stocks has increased 6% over the past year even though average earnings have decreased by 50%. This is not a recipe for success. In my experience, when tech stocks get valued at more than 10X sales, they are ripe for disappointment. 

2) The IPO Market Looks Greedy

Major tops in the tech market have been accompanied by surges in Initial Public Offering (IPO) activity -- and particularly unprofitable IPOs. The logic is simple: As markets rise and get frothy, it offers an opportunity for insiders to sell their shares to the public at high valuations. The higher the market goes, the more favorable the conditions for an IPO.

If you are a public-market investor, you want the opposite. You want to buy stocks when the IPO activity is low, not with large amounts of supply coming to market. It feels like we are hitting the top of a cycle here when large unprofitable IPOs such as Uber and Lyft come to market and then immediately fall.

Ride-sharing companies Uber and Lyft aren't profitable. Uber lost more than $1B last year. The company fell 8% in its first day of IPO trading. Its valuation is now half of the $100 billion valuation that "experts" were predicting at the beginning of the year. Uber IPO feels like a major red flag for the technology markets. 

3) The Trade War 

While the computer algorithms and traders are having fun playing day-to-day volatility over the news about escalating trade war between the United States and China, the bottom line is that the longer the trade war lingers, the more damage is being done to confidence in the markets. 

The technology market is a complex web of supply-chain interdependencies, and nowhere is this more important than in tech, where the U.S.-China connection rules markets. The daily stress of not knowing what's going to happen has damaged confidence in trade between the two largest technology economies in the world. 

Think of it this way: You are a technology company based in North America and you are trying to make your manufacturing and procurement plans for the next 3-5 years. Where do you build a factory? Who do you partner with? I was recently chatting with an executive on a plane who had been to Vietnam four times in the past year because he has been instructed to make alternative manufacturing plans in case his company pulls out of China. He said it's possible they'll pull out of China even if the trade resolution isn't reached. This is the kind of doubt and lack of confidence that is being introduced into technology markets every day the trade war gets extended without a resolution. It will depress confidence, capital spending, and earnings. 

To me, these three factors all add up to major concerns about the tech market. Of course, the only way to be right in technology is to invest for the long term. But at moments in time, technology markets because more highly valued and more risky than any other markets in the world, and this seems like it could be one of those times. It's not the right time to buy technology stocks.