2023 has been an unusual year in the stock market to say the least. Despite an enormous number of layoffs, continued interest rate rises from central banks around the world and increasing geopolitical tensions. The US stock market has rallied in the face of it all.
The Nasdaq 100 has been the real outperformer, up over 38% year-to-date, with the S&P rising over 15% in the same amount of time. But due to the heavy weighting of technology in the index, nearly all of the gains can be attributed to a few mega-cap tech stocks.
What is the reason behind that? And why do they continue to rally in the face of all these headwinds? This article will explore these questions and aim to make sense of this immense market rally.
2023 Performance vs 2022
The first thing to consider when trying to understand why large cap tech has rebounded so strongly in 2023 is how much these stocks were decimated last year. Some of the best companies in the world, producing billions in free cash flow, were cut by 50, 60, even 70% in some cases.
The likes of Meta, Tesla and Netflix were hit the hardest and they have seen some of the largest gains out of them all. While some of these stocks have had incredible moves in 2023, they are still yet to make up for the precipitous decline witnessed last year.
From peak to trough, these were the losses for the largest technology stocks on the S&P:
Take Meta, Tesla and Netflix as examples. For these stocks to reach their all-time highs once again, they would need to increase 4 times from the low they experienced last year!
While they may have had strong moves off the bottom, there is still a long way to go for some of them and puts into perspective the move that has been realised.
A ‘flight to quality’
Very few market participants would have expected a V-shaped recovery after one of the fastest interest-rate increases in history, but the market is doing just that. Only Nvidia, Microsoft and Apple have managed to make new all-time highs in 2023.
Time and time again, these companies demonstrate their earnings resiliency and the strength of their balance sheets, and in times of uncertainty, investors have flocked to them in a ‘flight to quality’.
Many institutional investors don’t have the luxury of switching from equities to fixed income or commodities if they feel more opportunity in other asset classes is present. They need to be positioned in stocks and are rapidly repositioning to companies with the most robust balance sheets, low debt levels and strong buyback programs.
With rising interest rates come rising debt service costs, but interest coverage ratios, a ratio that determines how easily a company can pay interest on its outstanding debt, is much higher in mega cap technology stocks than many other industries.
Companies with savvy financial departments were able to lock in long-term debt at record low levels, ensuring financial stability and low debt service costs for many years.
The mega cap tech stocks of the US are cash printing machines, and some of them such as Meta can pay off the entirety of their long-term liabilities with less than 6 months’ worth of cash generation. Most companies don’t even come close to this financial strength, and investors are rewarding it with a premium valuation on the stock price.
Valuation adjustment
As mentioned previously, the decline in stock prices in 2022 was extraordinary, and this led to multiple compression and a sizeable valuation adjustment in these stocks. To put this into perspective, high quality tech stocks such as Alphabet and Meta were trading at a discount to the S&P 500 on a P/E and Free-cash-flow yield basis.
It’s easy to assume that given the rise this year that the move has gone too far, but stepping back and factoring in the precipitous decline and that some of the best companies in the world were on sale for less than the average S&P stock goes to show how undervalued these companies were coming into this year.
On top of this, the stock price decline forced these companies to once again find financial discipline. When money was cheap and interest rates were at a record low, these companies were investing heavily into money-losing projects.
That has quickly reversed, and 2023 has been touted as the “year of efficiency”. Any mention of cost-cutting measures and getting back to basics has been rewarded massively, with Meta being the prime example.
As the company announced a reduction in spend on the Metaverse and thousands of layoffs on an earnings call, the stock gapped up 25% on the day, and has been climbing ever since. Combining this with low expectations for earnings, the market has realised that these are in fact the best places to be, especially when claiming a ‘wall of worry’ with several headwinds looming.
Earnings resiliency
In general, earnings were not as bad as feared. Wall Street underestimated corporate America’s ability to maintain margins and surprise to the upside, and this hasn’t even factored in the elephant in the room, AI.
AI has been around for years, but Chat GPT is the catalyst that captured the public’s imagination for its potential, and has resulted in a frenzy of activity around the perceived beneficiaries of AI, including Microsoft who owns OpenAI, the founder of Chat GPT and Nvidia, who are expected to provide the picks and shovels for the technology gold rush that is Artificial Intelligence.
There are certainly similarities to the dot com bubble in the excitement in the tech sector today, but many believe that this is just the beginning. Dan Ives for example, Chief equity strategist at Wedbush Securities calls this more of a 1995 moment and not 1999.
At the end of the day, these are companies with real products and real earnings, nothing like those seen back in the day adding “.com” at the end of their company name to jump on the bandwagon.
But nevertheless, we as investors should tread with caution. As Benjamin Graham says, the stock market is a voting machine in the short term, and a weighing machine in the long run, meaning that excitement and hype eventually dies down, and prices revert to the mean founded in real earnings.
