Technology-laden Nasdaq plunges on valuation concerns

It amazes me how people are often more willing to act based on little or no data than to use data that is a challenge to assemble. – Robert Shiller

It was a tale of two markets this past week with the tech-heavy Nasdaq Composite Index plunging 1.6% and the S&P 500 Index posting only modest losses. The Dow Jones Industrial Average bucked the trend lower by finishing the week with gains and closed at an all-time high. There was very little in the way of important economic data or earnings reports to move the markets last week, but news events on Thursday certainly had the potential to increase volatility. In England, Prime Minister Theresa May’s Conservative Party lost its parliamentary majority and, as a result, no party now has a clear majority. The surprising results could soften or slow down Brexit and maybe even force a second referendum or another election. Reaction to the stunning vote in Europe was muted, though, as the European stock market shrugged off the news. The European Central Bank (ECB) also met on Thursday and, as expected, decided to leave interest rates unchanged at zero percent. The ECB revised its inflation projections lower but gave no indication that rates would be cut again. Instead, the central bank forecast that the European economy would grow at a faster pace and that interest rates would remain at current levels for the foreseeable future. It also plans to continue its asset purchase program until the end of December. The other main event on Thursday was the testimony by former FBI director James Comey before the Senate Intelligence Committee on the investigation of possible collusion between Trump campaign officials and Russian officials. While both Trump and Comey accused each other of not telling the truth, it didn’t appear that there was a smoking gun and Trump himself proclaimed that he had been vindicated. But while the markets survived all of these newsworthy events on Thursday, it was a report by a Goldman Sachs analyst on Friday that apparently caught investor’s attention and sounded an alarm over the lofty valuations of certain technology stocks in the Nasdaq. Trees don’t grow to the sky and some of the stocks in the technology sector were overdue for a correction.

Last Week

Last week was a particularly slow one for economic data. The May ISM non-manufacturing index was in line with estimates and comfortably in expansion territory while factory orders in April registered their first decline since last November. This weakness should be temporary, though, as manufacturing activity has rebounded lately and there is plenty of optimism for a continued recovery. The number of job openings in the U.S. rose to a record high in April but the rate of hiring fell to the lowest level in a year as there aren’t enough qualified workers to fill vacant positions.

For the week, the Dow Jones Industrial Average rose 0.3% to close at 21,271 and the S&P 500 Index fell 0.3% to close at 2,431. The Nasdaq Composite Index tumbled 1.6% to close at 6,207.

This Week

As further evidence that inflation remains benign, the May producer price index (PPI), consumer price index (CPI) and import prices in May are all expected to be flat. Retail sales for May are forecast to edge up slightly after posting a healthy gain in April and May industrial production is only expected to show a modest increase. The preliminary reading for the June University of Michigan sentiment index is expected to stay elevated as consumers remain confident about the prospects for the economy.

The Federal Open Market Committee (FOMC) is widely expected to raise the federal funds rate by a quarter of a percentage point at its meeting on Wednesday and Fed Chair Janet Yellen will hold a news conference after the meeting.

There are only seven companies scheduled to report quarterly earnings this week and the most notable are Bob Evans Farms, H&R Block and Kroger.

Portfolio Strategy

The abrupt sell-off in technology stocks on Friday was primarily concentrated in the so-called FAAMG stocks, which is an acronym for five technology stocks that include Facebook, Amazon.com, Apple, Microsoft and Google, whose parent company is Alphabet. These five stocks have been the stock market leaders and have accounted for about 40% of the S&P 500 Index’s total return this year but make up only about 13% of the market capitalization of the index. On Friday, shares of Facebook, Amazon.com, Apple and Alphabet (Google) each dropped more than 3% while shares of Microsoft fell more than 2%. While the fundamentals and earnings growth prospects of these stocks are strong, investors had fallen in love with them and had bid their share prices up to unrealistic levels. Owning these high-flying technology stocks had become a “crowded” trade as they were over-owned by mutual fund and portfolio managers seeking to outperform their respective benchmark. Investing in stocks for growth at a reasonable price is one thing, but these stocks were trading at price earnings multiples that did not justify their current earnings growth rates. Sectors that benefited from the sell-off in these names were the energy sector and the financial sector, both of which had become undervalued and had underperformed the overall market this year. This rotation from overvalued, momentum-driven stocks to stocks that are trading at a discount relative to their fundamentals may continue as investors realize the risk involved in owning these high-priced names.