Vanguard Information Technology Index Fund ETF Shares (NYSEARCA:VGT) is a highly popular fund by Vanguard which had a tremendous performance this year as tech stocks had a stellar year but it might be getting a bit pricey at the moment based on pretty much every traditional metric. The popular fund is now up 45% year to date and investors can’t help but wonder if there is any room left for it to go much higher.
VGT holds a total of 321 technology stocks mainly (but not entirely) weighted by market cap so Apple (AAPL) and Microsoft (MSFT) alone claim 40% of its total weight and top 10 holdings claim 60% of its weight. Notice that the fund’s top 10 holdings don’t include Amazon (AMZN), Tesla (TSLA) or Meta (META) even though those tech companies have pretty large market caps and make up a significant portion of the Nasdaq index. The fund focuses more on software, hardware and semiconductor stocks that are directly involved in production of technology and technically Amazon is considered a retailer, Tesla a car company and Meta a social media company so those don’t have a big weight in the fund. Still, the fund managed to perform pretty well this year and matched the performance of Nasdaq.
Top 10 Holdings (Seeking Alpha)
This year tech stocks had a tremendous year but it was mostly driven by P/E multiple expansion rather than earnings growth. In the beginning of the year, Nasdaq index had an average P/E ratio of 24 which climbed to 35 as of November 20th which indicates a P/E expansion of 46% and it explains Nasdaq’s rally almost entirely this year. When you look at the top 8 tech companies that drove both Nasdaq (QQQ) and S&P 500 (SPY) indices higher this year, their P/Es now range from 26 to 121 with average number being 40.
It’s also noteworthy that the P/Es of these 8 companies rose anywhere from 41% to 161% if you don’t include Amazon whose P/E stayed flat this year. The average P/E expansion was 50% and all these companies approaching top range of their all-time P/E ratios.
Meanwhile, earnings aren’t growing anywhere nearly as fast. We’ve seen Amazon (AMZN) and Nvidia (NVDA) post strong earnings growth this year and Meta (META) also did well but the rest of the mega cap tech companies lagged in terms of earnings growth especially in comparison to their stock price growth. For example, Apple’s stock price is up 54% year to date while its earnings were only up 2% YoY so the entire rally came from multiple expansion. Basically tech companies aren’t making more money but investors are paying a bigger and bigger premium for every dollar they are making.
Tech stocks are also stretched out in terms of PEG values. We know that not all P/Es are created equally considering that different companies have different growth rates so it’s not fair to assign the same P/Es to two companies when one of them is only growing at 3% while the other is growing at 30%. PEG ratio metric takes a company’s growth rate into account while looking at its P/E ratio. Anything under 1 is considered super-cheap and anything under 2 is considered reasonably valued. Anything above 3 is considered expensive. Out of the major tech stocks, only one of them have a PEG ratio below 1 and the rest of them have PEG ratios above 2. Notice how Apple’s PEG is through the roof because the company’s P/E of 32 is much higher than its current growth rate of less than 2%.
Of course just because stocks are very expensive doesn’t mean they can’t get even more expensive. If the last 14 years have taught us something, cheap stocks seem to remain cheap for a long time while expensive stocks seem to keep getting progressively more and more expensive. Below shows the historical forward P/Es of the technology sector within S&P 500 index broken by sub-sectors such as overall IT, Application Software, Data Processing, IT consulting and Systems Software. Notice the slow but sure uptrend from 2009 until now where P/E ratio of the entire sector has been rising year after year.
S&P Tech Valuations (Yardeni)
Many people thought this was because the Fed’s monetary policies have been highly accommodative and it was bullish for tech but this would reverse as soon as the Fed changes its policy. Last year, it was almost proven correct as Nasdaq and tech stocks took a dive after the Fed started to hike rates and launched its quantitative tightening program but this year tech stocks started to defy gravity again even though there has been no change in Fed’s policies. It is highly expected by the market that the Fed will loosen its policy and come to the help of the economy as soon as the first signs of trouble show as it often did in the past.
CME’s [CBOE] FedWatch tool looks at Fed Funds Rate Futures market to calculate markets’ expectations of Fed rates moving forward. The tool, which is widely used by bond markets, now sees virtually no chance of another rate hike and 30% chance of a rate cut by March, 60% chance of a rate cut by May and 80% chance of a rate cut by June. For the second half of 2024, investors are almost certain about a rate cut and a looser monetary policy by the Fed.
Probabilities of Fed Funds Rates (CME)
We could see that tech stocks are also expecting Fed to cut rates as soon as this spring based on the recent rally. Inflation is coming down significantly but so are earnings. The expectation is that once Fed cuts rates, it will stimulate the economy in a very quick fashion and earnings will start growing rapidly without causing any additional inflation in the economy. Time will tell whether this is a realistic expectation. There is also the risk that if the Fed were to cut rates and inflation came back raging, it would have to be super aggressive about battling the inflation again which can derail tech stocks in the medium term.
For the time being valuations are very stretched in technology sector but the sentiment is extremely strong. In the short-to-medium term, sentiment can override valuations and keep stocks rallying even if valuations don’t support higher prices. In the long term valuations tend to win.
Should you be bullish or bearish on tech stocks in general and tech funds like VGT? It depends on your age and time horizon. In the long run, tech stocks outperform and I am not talking about a 5, 10 or even a 20 year period. Nasdaq index has been around since 1971 and it’s been outperforming for almost the entirety of its existence of 52 years.
Nasdaq vs S&P 500 52-year Chart (longtermtrends.net)
If you are a younger investor with multi-decade time horizon, I’d be all in technology and VGT would be a great place to park your money for the next 30-50 years. In the long run, valuations tend to work themselves out. If you are close to retiring or already retired, then you want to be very careful at current valuations because they look overstretched. VGT’s long term chart looks amazing as it is up 808% since inception but this can also mean that it’s overdue for a deep correction in the coming years and you don’t want to take that risk if you are close to retirement or already retired.
If you have plenty of time on your side, by all means keep holding this great fund for decades to come.
