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Soaring values of technology companies have dominated the market's bull run, but now they are getting way too expensive as the earnings picture continues to deteriorate, a top tech analyst warned.
The tech sector is now trading at 21.4 times forward earnings, the highest level in 15 years, according to Toni Sacconaghi, AB Bernstein's senior technology research analyst. This rapid multiple expansion, which is the most pronounced this year, has reached a worrisome degree given earnings are expected to have a "startling" decline over the next 12 months, the analyst said.
Source: AB Bernstein
"Risk is increasing in tech, especially with high priced stocks," Sacconaghi said in a note Monday. "Part of tech's challenge is that it is comping against a tough 2018. Tech's earnings lagged the broader market last year, as tax reform more favorably impacted other sectors and expectations for 2020 don't improve dramatically."
Earnings for the tech sector are expected to drop by 9.9 percentage points on an equal-weighted basis in the next 12 months, compared with the broad market's 1.3 percentage points decline, according to Bernstein. The revenue picture is also not uplifting with the group expected to grow just 0.5% while the overall market is set to gain 4.7% in sales, Sacconaghi said.
"The largest stocks are emblematic of current year tech struggles: among the 17 largest cap tech companies, seven have flat to negative forward earnings growth. In particular, overall earnings growth is expected to be double digit negative for Semiconductors and Tech Services," the analyst said.
Sacconaghi is frequently the top tech analyst in the annual rankings from Institutional Investor magazine. His picks in the space have an average one-year return of 21%, according to TipRanks, which places him among the best on Wall Street.
While sounding alarms on tech's sky-high valuations and their grim earnings picture, Bernstein hasn't written off the group altogether. In fact, the firm recommends investors add cheaper names in the sector.
"While collective valuations are high, fundamentals for tech remain strong," Sacconaghi said, noting the group has above-average five-year growth expectations as well as having the highest-quality score across sectors.
The firm kept its market weight rating on tech, while encouraging investors to be cautious on "expensive names with decelerating growth or low quality scores, currently concentrated in technology services and smid-cap software," Sacconaghi said.
Bernstein screened tech stocks that have a relatively cheap valuation while scoring high in the quality factor. The stocks include Applied Materials, Dell Technologies, Lam Research and Skyworks Solutions.