Concerned about valuations? Here’s a way to ‘rent’ tech stocks into year-end
If you’re worried about stocks getting overvalued after this recent rally, especially in the technology space, we will review a way to “rent” tech stocks — not own them — so a trader can participate in any potential upside without risking a lot in case there’s a pullback. But first let’s review some of the valuation concerns out there. I’m sure you’ve heard or read or the past few months the notion that stocks are expensive relative to bonds. How expensive (or cheap) equities are relative to bonds is a measure of the equity risk premium, a financial concept that represents the additional return or compensation that investors expect to earn for taking on the higher risk associated with investing in stocks compared to investing in a risk-free asset, such as U.S. Treasury Bonds, or at least a lower-risk asset such as investment grade corporate bonds. Effectively, it quantifies the extra return investors demand for the added risk of holding stocks instead of “safer”, lower-risk investments. Stocks are considered expensive relative to bonds when their prices, by a common valuation metric such as the P/E (price-to-earnings) ratio are high compared to historical averages or when they are trading at a significant premium compared to the yields offered by bonds. To ease comparison, one could calculate the “earnings yield” of equities. Since the earnings yield is earnings divided by price, one can simply invert the P/E ratio. For example, the current P/E of the S & P 500 P/E is 20, so one dividend by 20 equals a 5% earnings yield. If Treasuries are yielding say 4.125% (where the US 10-year closed Friday), then the equity risk premium is 5% minus 4.125% or .875%. This supposedly means you get less than 1% extra yield for the risk of owning stocks versus Treasuries. Where this analysis falls down is that corporate earnings grow over time, while bond coupons do not, and the coupons are worth less and less, inflation-adjusted, after each passing year. If we assume that inflation has averaged about 3% per year over the past 25 years, and nominal (non-inflation adjusted) GDP growth is 4.8%, the 4.125% paid by 10-year US Treasury bonds begins to look a lot less attractive. Meanwhile, S & P 500 earnings over the same period have grown at a pace of more than 7% per year. To my mind, a diversified stock portfolio is less risky than bonds over the long term for this reason. Inflation risk is borne more heavily by bonds. Bond yields are influenced by prevailing interest rates. When interest rates are low, as they have been in many parts of the world in recent years, the yields on bonds are also low. As rates fall, the value of a bond rises. Consequently, over the past 30 years or so, holders of bonds have collected coupons and seen the value of their bonds increase. Advocates for bonds suggest that higher yields plus the potential for capital appreciation increase their relative attractiveness. Add to this the fact that market sentiment and investor psychology play a much more significant role in pricing equities than bonds. When investors are optimistic about the economy and corporate earnings, they are willing to pay higher prices for stocks, leading to higher P/E ratios, because this reflects greater growth expectations. Sentiment hasn’t been terrific recently, and if it deteriorates that presents a downside risk for stocks. Time to go ‘BIG’? So if stocks are vulnerable near-term, but are almost always a better bet in the longer term, what to do? I was asked on a recent podcast what to do about stocks, and I said go “BIG” or go home. BIG is my acronym meaning buy idiosyncratic growth. That is, buy stocks in companies that are growing sales, earnings, and free cash flow for reasons of their own. The problem here is that many of these companies in particular that I like, such as Nvidia, Tesla, and Microsoft are already up big this year. The Technology Select Sector Index isn’t trading at a P/E of 20 (earnings yield of 5%), but closer to 31. So the corporate earnings yield is 3.2%. Worse than that, earnings have been declining for the sector since peaking in Q2 ’22. What to do? I still believe technology stocks outperform in the long run (over many years), but I’ll acknowledge that things look a bit dicey right now. To accommodate those realities I’ve adjusted my “BIG” acronym to “RIG”, rent idiosyncratic growth. A call option gives the holder the right, but not the obligation to buy the underlying. If the technology sector, up 50% year to date, represents the best proxy for idiosyncratic growth, but also the most vulnerable sector in the event market sentiment deteriorates, a call option is a better way to play. This is particularly true now because call options premiums have fallen to two-year lows. A 3-month, 2.5% out-of-the-money call option on Technology Select Sector SPDR (XLK) has an “implied volatility” (the way options traders think of an options price) of just over 16% last week, and closed only slightly higher than that on Friday. Rent tech One could buy the March $191 calls in XLK for $5.50 contract on Friday, just under 3% of the closing price of XLK shares. XLK YTD mountain XLK, Year-to-date In the long run, stocks outperform bonds because inflation erodes the real value of those future dollars, but the best companies have historically seen earnings grow at a pace far faster than inflation. Don’t want to chase technology stocks up 50%? I don’t either, but options give you a lower-risk way to play. Phrase it how you want, “try before you buy”, “rent-to-own”, however, you want to think about it. The following names will be reporting earnings within the next two weeks. We own the names highlighted in green – and you’ll observe that we own some technology and discretionary names on that list. DISCLOSURES: (Long Adobe, Micron, Oracle) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. 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