The stock market has hit a rough patch with high-flying tech stocks facing pressure. This is the first period of volatility after the bear market crash earlier this year. After such a swift recovery for the stock market, it's natural for investors to wonder whether this is the beginning of a more severe correction and perhaps a repeat of the late 1990s/early 2000s dot-com crash.
Some perspective is useful whenever the market becomes choppy. Despite the recent pullback in tech stocks, the NASDAQ Composite has still risen around 23% this year, beating the S&P 500 and Dow Jones Industrial Average. Since 2015, the so-called FAANG stocks - a group of fast-growing technology companies - have gained over 350% compared to the S&P 500's 78%. As a group, these stocks have done quite well despite recent stumbles.
However, the point is not to have invested solely in tech stocks. Instead, it's that they are an increasingly important component of any diversified portfolio and a growing proportion of the market index. This reflects the fundamental changes to our economy over the past two decades with online retailers, mobile technology, digital streaming services, and other advancements changing our everyday lives.
Thus, the most important different between now and the early 2000s is that many of these companies are not only profitable but have established business models. This is in stark contrast to the dot-com crash when highly-valued internet companies were backed by little more than promises. In fact, today's companies span many of the traditional stock market sectors beyond Information Technology. These include Consumer Discretionary, Communications Services, and more since, in many ways, technology allows companies across industries to gain scale with high profit margins.
The challenge for markets is that many of these companies' stock prices went parabolic in recent weeks, rising at an unsustainable pace, as seen in the first chart below. The issue is not whether these companies have grown quickly in the wake of the pandemic or if they are going-concerns, but rather what valuations are appropriate. Overall, the S&P 500's valuation levels are approaching historic highs last experienced during the 1990s dot-com boom. This is partly because stock prices have recovered since March and partly because earnings estimates have fallen due to economic uncertainty.
However, if COVID-19 can continue to be contained and the economy and corporate profits can rebound over the next year or two, then valuation levels will likely also return to more moderate levels. Thus, the most important driver of the stock market overall and tech stocks in particular is still the economic recovery. Long-term investors should continue to stay diversified across sectors and markets as this takes place.
Below are three charts that highlight important perspectives on tech stocks.
1. Tech stocks rose rapidly during the COVID-19 crisis
Fast-growing tech stocks not only managed through the recent bear-market crash, but many grew swiftly as consumers and businesses shifted online. However, their stock price increases accelerated to unsustainable levels, resulting in the recent pullback.
2. Tech-related sectors are experiencing faster earnings growth
Many sectors contain what are often considered to be technology stocks, including Information Technology, Consumer Discretionary and Communication Services. These happen to be the best performing sectors over the past year, especially post-crisis, since they are expected to see faster-than-average earnings growth as the economy recovers.
3. The market recovery and tech stock prices have driven valuations higher
Due to recent market and tech stock performance, overall stock market valuations are nearing levels not seen since the dot-com bubble. This reflects uncertainty around corporate earnings. If the economy can continue to recover and profits return, then these valuations may fall back to more attractive levels.
The bottom line? Tech stocks have helped to drive the market higher this year. While volatility and uncertainty may continue, the situation is quite different from the dot-com crash two decades ago.