How should the long-term investor think about US technology stocks?
Many have argued that US technology stocks have decoupled from interest rate levels but it is important to understand the price developments of financial instruments cannot be compared to interest rate levels. This is because the one time series is stationary (fluctuates around a mean – in this case interest rates) and the other is not, so these two time series will always divert at one point.
The reason why there is not necessarily a decoupling is that equities do not have fixed cash flows like bonds. Besides the discount rate, investors must take into account operating margin developments, revenue growth, and investment needs. We actually tried to see if there was any relationship between the free cash flow yield of the Nasdaq 100 and the US nominal or real yield. There is not because of the other factors above. In financial markets it is often not the level but the rate of change in that level. But even if we look at the change in nominal or real yield we do not observe any strong relationship to the expected future change in valuation levels. Another way to think about this is, that if it was so easy to reduce equity markets to simple one dimensional relationship we would all be rich.
What matters for long-term equity returns are two things. Valuation starting point and future growth in free cash flows. As US technology companies have slashed costs since the 2022 downturn, the free cash flow of Nasdaq 100 companies is coming back fast (see chart below). Free cash flows have grown 12% annualized since 2004 and this growth rate was also observed in the fours years before the pandemic. Right now, the free cash flows are catching up with the long-term trend which means that they are growing faster than 12% which are maybe justifying why the 12-month rolling free cash flow yield looks a bit expensive relative to the period just before the pandemic.
The key risk to US technology stocks is the valuation as the current free cash flow yield of 2.9% is substantially below the around 4.2% free cash flow yield observed the year before the pandemic. I’m not sure the structural growth rate has changed, unless generative AI is the real thing on growth. If Nasdaq 100 free cash flow catches up with trend over the next year and the Nasdaq 100 remains unchanged then the 12-month rolling free cash flow yield gets to 3.8%, so not as expensive suddenly. It should be clear by now that in the very short term the break or not of the US 10-year yield above 5% is key, but medium term the growth rate will dictate what happens to US technology stocks.