Tech Party Will Soon Be Over



  • Nasdaq 100 grew by 21.8 percent this year.
  • Valuations, changes in positions and sentiment shows the party is over.
  • It is time to short, partially liquidate, or at least hedge positions in US tech stocks.

It is always hard to accept that the party is over. Especially when we are talking about periods of growth in the stock markets. Usually one may find a number of explanations and reasons why prices should continue to grow and how bears do not understand some future potential.

However, current tech stocks valuations, investor sentiment, fundamental reasons and other factors show that correction is coming. Thus it seems to be the perfect time to start shorting, or at least liquidating positions.

Investor sentiment

Investor sentiment towards tech stocks changed dramatically over the last month. In June it was the most overweight it’s ever been (including the tech bubble). However, as according to survey conducted by BofAML, financial managers started to sell this position heavily in July:

Source: heisenbergreport.com

Outflows are confirmed by Commodity Futures Trading Commission data. Commitments of traders reports show that in the middle of June large speculators had three times as much Nasdaq e-mini contracts as they had in the middle of July.

While institutional investors, who use futures to for hedging purposes, have decreased their short positions by approximately four times. Meaning that they decreased their long exposure and thus had to close out hedges in futures.

Changes in NQ positionsSource: timingcharts.com

In the chart above green line depicts positions held by long speculators, while blue line shows changes in institutional investors positions. As one can observe, sharp changes historically are usually followed by a correction.

Valuation metrics and statistics

If one consults most common valuation metrics, technology stocks seem to be overvalued. Analyzing different S&P 500 sectors, technology has one of the highest Shiller P/E ratios of 33.6, lead only by real estate with Shiller P/E ratio of 49.2. If compared to recent history, three years ago (and a year ago) the same Shiller P/E for tech stocks in S&P 500 index stood below 25:

SPY Technology P/ESource: gurufocus.com

In addition to that, as according to data provided by Bloomberg, Nasdaq 100 PE stands at 26.65, while other main indices have much lower ratios – S&P 500 PE ratio is 21.8, Dow Jones Industrial Average PE is 18.9 and EuroStoxx 50 has PE ratio of 19.6. Thus it is not only that technology seems expensive in historical perspective, but it is actually expensive when compared to other stock indices.

Of course, these valuations are justified as long as tech companies show aggressive growth. Nevertheless it is rather unlikely that current levels of P/E are sustainable. Especially when one considers the recent growth of Nasdaq 100.

Since the beginning of this year Nasdaq 100 returned almost 22 percent. While over the periods of 10 and 15 years until July 2016, CAGR was at least two times lower:

Period CAGR
2001.07-2016.07 6.8
2006.07-2016.07 10.7

This means that over last 7 months, the Nasdaq Composite grew twice as much as it grew over any 12-month period in the last ten years. What, from statistics standpoint, leaves us with two options:

1) Either Nasdaq should fall so that growth moves closer to the long term CAGR;

2) Or Nasdaq should stop growing until 2019-2020 so once again growth moves back to long term average;

Thus even if rich valuations may be somewhat explained, when one adds the miraculous short term growth rate, it becomes apparent that unless there is some fundamental shift in technology, which dramatically boosts business for tech companies, such growth and valuations are unsustainable.

Other indicators – PUT/CALL ratio is increasing

Option market is also a great leading indicator which might help to decide whether it is time to get out of a position. One particular and easy to find tool is put/call ratio, which basically shows ratio between bears and bulls.

PUT options are usually bought either by those who are convinced that market will go down or are hedging their long positions in underlying. While CALL options are bought by those who expect prices to increase further.

Over the last few months put/call ratio on QQQ (the most popular ETF tracking Nasdaq) was increasing. Since mid April until end of June it increased from 1.75 to 2.25. While as according to the latest data provided by CBOE, it now stands at 2.34.

PUT/CALL ratio on QQQ

Source: optionistics.com

In addition to put/call ratio, open interest and volume ratios also increased during the same period. What usually corresponds to more investors having bearish sentiment.

Correction is imminent

If one looks at all of these metrics and numbers separately, everything may appear to be justifiable. Valuations may remain rich for long periods of time, large speculators might start selling future contracts on profit taking and buying of put options might increase due to upcoming earnings season.

However, if we add all of these together, in addition to rapid growth (twice as fast as historical), it becomes very hard to come up with a sound explanation why all of this data should not be at least worrying.

Thus, even if You refuse to agree that the party is over, it would be only rational to hedge or at least partially liquidate positions in technology. Of course, over the next 3 years Nasdaq 100 might double in value. However, by selling now and buying back after correction, You can get a better price and be rather better prepared for the upcoming rally.