Is the savage “after-market” reaction to Netflix’s subscriber growth “miss” a sign that the remarkable run in technology stocks could be coming to an end?
That is the question on the minds of traders as they head into what could be a critical quarterly earnings season for the sector that has been propelled by the extraordinary performance of the likes of Netflix, whose shares had doubled in 2018 and quadrupled over two years.
The reason for a 15 per cent overnight sell-off in Netflix is not because it missed its profit numbers. Rather, it was punished because it only added 5.2 million users during the quarter, a million fewer users than it had forecast.
It is a turn of events for the stock, which forms part of the fabled FAANG grouping of US tech titans, for Facebook, Apple, Amazon, Netflix and Google parent Alphabet, given it is loved by investors and users and has avoided the criticism of its peers.
Earlier this month, The Economist ran a cover story on the “tech giant everyone is watching” detailing how Netflix will spend over $US12 billion ($16 billion) on content to produce four times as many films as Hollywood’s largest studio.
But the apparent failure to please the market could be the first demonstration that investor expectations have now become too excessive and a correction is on its way.
For the tech bears, many of whom have been squeezed by an unprecedented run in high growth and momentum stocks relative to apparently cheap value stocks, this profit season will finally bring vindication.
Bears write a long list
And the list of reasons to be wary of these market-leading stocks is growing.
Last week Morgan Stanley’s research analysts told clients to reduce their holdings in technology stocks, which it says have benefited from a “false sense of security” in the last few months and are not “immune” from increased bearishness.
“When we hear things like technology is no longer cyclical or technology is a low vol/risk sector now, we cannot help but think its vulnerability has reached a concerning place,” Morgan Stanley’s equity strategists said.
In February, the broker downgraded tech stocks from overweight to equal weight, but the sector has continued its run on the back of strong earnings growth that the analysts said had drawn in investors “like a lifeboat on choppy waters”.
Some cynics regard these sector rotation calls by strategists as a means of generating more brokerage. But they offered several compelling reasons why the remarkable out-performance of tech stocks may have run its course.
The risk/reward of tech stocks sets up poorly for a few reasons, the analysts argue. One is that consensus forecasts are for 25 per cent earnings growth in the second quarter, which is “achievable” but leaves little room for error.
Relative valuations have also reached extreme levels with forward price-earnings of the tech sector and the broader Nasdaq index relative to the broader S&P500 at more than two standard deviations above the post-crisis average.
“These are not bubble valuations like in the late 1990s, but we think it more likely we revert to the near-term mean than move higher from here.”
Not immune to trade wars
The brokers are also concerned about trade wars given tech stocks have been among the biggest beneficiaries of lowered trade barriers and have among the highest revenue exposures to China, at about 8 per cent.
The brokers have also called out the “crowded” nature of the tech trade as more hot money chases returns in the sector that has been a winner.
The over-indexing of institutional investors to tech stocks does not necessarily mean that there’s no more upside, they argue. But it does “create liquidity risks if fundamentals change, investors begin to chase relative performance in other areas, or sentiment turns”.
Finally, Morgan Stanley argues that as technology stocks have become more mature and have leveraged their enormous scale, they have delivered impressive growth in free cash flows which has justified their share price gains.
Over time, the performance of tech stocks has become more correlated with increases in free cash flow margins.
But these margins will be impacted by more capex spending, which is increasing. About 40 per cent of the growth in capital expenditure in the first quarter of 2018 came from the technology sector.
“Whether investors are willing to look past this and pay for growth from the capex is an open debate, but we note that performance follow-through for sector leader Google after it increased capex spend last quarter did not send a positive message and we have shown that those companies increasing capex by the most have broadly been underperforming peers,” Morgan Stanley wrote.
Still a tough short
But the end of tech’s stellar run has been called before and those that have bet against these firms are in a world of pain.
For instance, the reputation of hedge fund legend David Einhorn has been dented by bets against runaway stock Netflix and Amazon.
He is among several investors who are adamant the market is paying too high a price for high-growth stocks, and that too much capital, whether it is directed by humans or algorithms, is chasing hot stocks at the expense of everything else.
At least on a relative basis, these stocks are at extreme levels.
“The relative valuation of growth/momentum stocks versus value stocks has now reached a 20-year extreme – a level not seen since the peak of the dotcom bubble,” Melbourne based hedge fund L1 Capital told investors in a monthly update.
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