Again, when I say that cash is your friend, I mean it. And when momentum is red… I stay clear of trying to call a bottom. Executives aren’t buying their own stocks at these declining prices… So, why would I?
There is no shortage of talking heads on CNBC and elsewhere trying to catch a falling knife. I’m not going to be one of them. And I’ll show you today – again – why there appears to be much more damage ahead. The reason? Well, look at what happened to Amazon.com (AMZN).
Amazon Collapses Again
It was another bad day on the tech front. The NASDAQ fell nearly 5% on the day. Alphabet (GOOGL) bombed. Microsoft (MSFT) cratered. Apple (AAPL) couldn’t find support. And Amazon? It plunged 7.6% to finish the day at $2,328.14.
Now, Amazon is supposed to be the company that owns the U.S. supply chain. But a funny thing is happening in the tech sector that too many people seem to be ignoring.
We’re undergoing a massive downward trend known as “Value Compression.” With interest rates surging (the 10-year bond topped 3.08% today), tech stocks can no longer justify their lofty valuations.
A stock trading at 35 times earnings with little profitability can’t justify a return in an environment where GDP is struggling, inflation is rising, and the Fed is jacking up interest rates. To justify a price to earnings ratio of 35, a company must pay 100 percent of its earnings (profits) to its investors for 35 years. That’s pretty simple.
If it trades at a price to earnings of 16, then it would reflect a 16-year return of all profits. A higher PE ratio means that investors are effectively paying MORE for less, but they’re hoping that the company will aggressively increase profits to justify a higher price in the future.
Price to Earnings vs Price to Sales Ratios
What about companies that trade at a high “price to sales” ratio. What does that mean? It means that the stock is trading in relation to its annual revenue. If a stock trades at a price to sales of 10, that means that to justify the price of the stock, the company must pay 100% of its REVENUE for 10 years to its investors.
Do you notice the difference? A PE ratio measures the years of profits paid to the investors. A PS ratio would measure years of REVENUE paid.
Revenue is a much different animal. Profits are a percentage of revenue. Revenue is a gross number, which means that the company would theoretically have to pay 100% of every dollar it earns for the number of years reflected in the PS ratio.
Take a company like Datadog (DDOG), which has a PS ratio of 34. To justify anyone’s investment, the company would need to pay 34 years of revenue to its investors. No profits, no R&D spending, and no taxes, which is pretty much illegal.
This valuation is completely insane. Either the company must grow at a breakneck pace and become profitable fast, or the stock is going to decline. My bet is on the latter.
What About Amazon?
Now, I mentioned Amazon, one of the world’s leading tech companies and most widely held stocks across institutional and retail portfolios. For a decade, Amazon has benefited from the Federal Reserve’s cheap money policy and low interest rates. The stock is now off 31.5% for the year.
And, even though it has one of the lowest PS ratios of all FAANG stocks, it has not been immune from valuation compression. The chart below is a measure of AMZN’s PS ratio dating back to 2012.
The compression has been accelerating over the last few months. Amazon’s PS ratio is now at its lowest level since 2016. And there might be even more downside.
This should be a concern to anyone who owns other big tech stocks. A price to sales ratio of 2.5 is not very high in comparison to say the 10.97x of Microsoft.
Valuations might not mean much on the way up… but they certainly do on the way down. I’m steering VERY clear of overpriced stocks in the tech sector. Instead, I’m focused on tech stocks with good fundamentals and cheap buyout multiples. We’ll discuss a few ideas on Friday.