Does Tech Have Legs?

With the exceptionally strong performance of the technology sector over the past 18 months, some investors have been wondering whether tech could be in a bubble, similar to the dot-com bubble of the late 1990s, which ended badly. As it turned out, although the internet would in fact change many things, the expected gold rush didn’t happen overnight.

With A.I. igniting this latest technology spending wave it’s a great time to make an objective comparison of this era to the 90’s dot com boom.

This comparison is centered around the two primary categories:

Reasons why the two eras are different

• 3 Reasons why tech’s latest rise does not look like a valuation bubble

• 2 Reasons why in spite of that, investment diversification beyond tech is still important

1. Tech valuations are not at extremes

A bubble is a disconnect between how companies are valued (i.e., the prices they trade for), and their business fundamentals (i.e., their earnings, cash flow, book value, or other financial metrics). Looking at the long-term valuations for the tech sector,

As the chart below shows, at the peak of the dot com tech bubble in March 2000  the sector traded at a forward price-earnings (PE) ratio of almost 60. But recently the sector's PE ratio has been at only about half that level. In other words, based on earnings, tech is earning its value.

Past performance is no guarantee of future results. The forward price-earnings ratio measures stock price divided by average earnings estimated by analysts over the following 12 months. Analysis based on technology stocks in Fidelity top US 3,000 stocks by market capitalization. Data as of March 29, 2024. Sources: Haver Analytics, FactSet, and Fidelity Investments.

If you compare the sector's valuation to that of the broader market then the picture looks even less worrying. Yes, tech stocks have gotten more expensive recently—but so has the entire market, on average.

Past performance is no guarantee of future results. The forward price-earnings ratio measures stock price divided by average earnings estimated by analysts over the following 12 months. Analysis based on technology stocks in Fidelity top US 3,000 stocks by market capitalization. Data as of March 29, 2024. Sources: Haver Analytics, FactSet, and Fidelity Investments.

If you compare the sector's valuation to that of the broader market then the picture looks even less worrying. Yes, tech stocks have gotten more expensive recently—but so has the entire market, on average.

2. Tech Earnings are coming through—supported by margins

Tech has been delivering the goods when it comes to profits vs sales. This has been primarily driven by margin expansion (meaning, for every dollar of sales, how much money does a company end up keeping in the form of operating profits).

As the chart below shows, operating margins aren't far from all-time highs, and they've been generally improving and almost double those of March 2000.

3. Earnings momentum is giving a bullish signal

The chart below shows this by comparing the forward earnings estimates, for tech at a given point in time, to forward earnings estimates from a year prior.

If you look at the most recent upturn, it looks a bit like a hockey stick—showing strong positive momentum. Usually, we only see that kind of a "hockey stick" formation on the way out of a recession, and the 2 most recent other times we've seen it have been coming out of the pandemic and coming out of the 2007 to 2009 bear market. What it has historically signaled is that this kind of earnings recovery is durable—meaning, we've then seen higher odds of continued earnings growth in the second or even third year after that inflection point.

Furthermore, historically, the greater the momentum, the more likely it is that the stocks advance and that they outperform the market. In this case, we've seen top-quartile momentum (measured by the steepness of the hockey stick-style rise).

In other words, it's not just that tech doesn't look like a bubble, it could still have more room to run.

4. That said, tech's relative performance has indeed been well above average

Looking ahead, investors need to balance this strong case for tech against some subtle caveats.

One reason why investors have felt that tech might be in a bubble is because it has performed much higher than other sectors. With that in mind, from an objective standpoint, we could also say at this point all the other non-tech sectors have yet to be appreciated.

Historically, analysis suggests that this is another important signal. While tech valuations may settle the broadening market of “everything else” is likely to catch up.

5. Technology investing like all other economic sectors should be about rewarding long-term investors.

Of course, this is not to say that investors should be making any drastic moves to shift out of ell certain sectors or double down on others. Most investors are best served by holding a well-diversified portfolio that's tailored to their goals and by sticking with a long-term financial plan.

But for investors worried about a tech bubble, here's what to remember: The current period looks very different from the dot-com bubble. Tech valuations are not at extremes, and earnings suggest that the stocks could still have more room to run. That said, tech shouldn't be the only sector investors own. A broad portfolio—including some exposure to cyclical sectors such as real estate and financials—could be a better approach from here than a tech-only portfolio.