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US stock rally driven more by valuation growth than earnings, leaving tech names vulnerable: Innova
Invest
US stock rally driven more by valuation growth than earnings, leaving tech names vulnerable: Innova
The strong gains in US stocks over the past year, particularly in the technology sector, have been driven more by expanding valuations than underlying earnings growth, leaving them exposed to a potential correction if interest rates remain higher than expected, according to Innova Asset Management.
US stock rally driven more by valuation growth than earnings, leaving tech names vulnerable: Innova
The strong gains in US stocks over the past year, particularly in the technology sector, have been driven more by expanding valuations than underlying earnings growth, leaving them exposed to a potential correction if interest rates remain higher than expected, according to Innova Asset Management.
Innova Managing Director and Co-Chief Investment Officer Dan Miles said that while US corporate earnings have been rising, this has not been enough to justify the surge in share prices.
"Equity prices rising in line with earnings is reasonable, however, it is unreasonable when prices rise much more than earnings; in this situation, you also have multiple expansion explaining the price gains," Mr Miles said.
An analysis by Innova found that almost two thirds of the near 30% rise in the S&P 500 index over the year to March 31 was attributable to expanding price-to-earnings multiples, rather than earnings growth.
The trend was even more pronounced among technology stocks, with the likes of Nvidia, Microsoft, Alphabet (Google) and Meta (Facebook) seeing their share prices far outpace any upgrades to their earnings outlooks in the March quarter.
"Over the last year, Microsoft, Alphabet, Amazon and Meta have been the standout companies where the gains in their stock prices were least backed by earnings revisions," Mr Miles noted.
He warned that interest rate sensitive stocks trading on very high valuation multiples are now vulnerable as markets digest the reality that borrowing costs may need to stay higher for longer to tame inflation.
"Until March, this proved incorrect – the market, particularly the tech sector, continued to rally even as rate cut timing was pushed out and the magnitude of cuts reduced. This seems to be correcting now, but who knows if this is the start of a true re-rating or just a blip in the road," Mr Miles said.
Looking ahead, Innova believes a still-strong US economy could see earnings and share price momentum broaden to other sectors that have not participated in the rally to the same extent as technology names.
"If the US economy remains strong, it seems logical that companies exposed the cyclicality should be beneficiaries," Mr Miles said.
The findings highlight the growing concerns among some investors that stock valuations, especially in the tech sector, have become stretched and are not supported by fundamentals, leaving them at risk of a sharp pullback.
While the US Federal Reserve has recently paused its interest rate hiking cycle, persistent inflation and a resilient labour market have led many analysts to push back their expectations for the timing and scale of any future rate cuts.
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