IGM - IGM: Rich Valuation Means Downside Risk Is High In The Near Term

2023-09-20 08:57:26 ET

Summary

• Technology stocks have performed well in 2023, but there may be more volatility ahead.
• The iShares Expanded Tech Sector ETF has had a strong rally in 2023, but its valuation is high.
• The Federal Reserve's tightening monetary policy and declining liquidity pose downside risks for IGM and the technology sector.

Introduction

Technology stocks have performed quite well in 2023. In fact, the sector has recovered most of its losses since reaching the trough in October 2022. Will this rising trend continue in the remaining of 2023 or do we need to be prepared for more volatility. In this article, we will analyze iShares Expanded Tech Sector ETF ( IGM ) and provide our insights and recommendations.

ETF Overview

IGM invests in mostly large-cap technology stocks in the United States. The fund will benefit from several important growth trends in the upcoming decades. However, its valuation appears quite rich especially after a strong rally in technology stocks in 2023. In addition, the Federal Reserve’s tightening monetary policy means that many high valuation stocks will remain under pressure. Therefore, we think investors may want to wait on the sidelines for a better entry point.

Fund Analysis

IGM had a good rally in 2023

Before we dive into the analysis of IGM, we will first take a look at its performance recently. Following an abysmal performance in 2022, IGM has rebounded strongly in 2023 especially thanks to strong earnings reported by Nvidia ( NVDA ) in May 2023 that sparked a rally in technology stocks. As can be seen from the chart below, IGM has delivered a total return of 40.4% year-to-date.

IGM will benefit from several important secular growth trends

About 60% of IGM’s portfolio belong to the category of growth stocks. In addition, technology stocks tend to exhibit strong growth characteristics in the long run. Therefore, the portfolio itself has a very strong growth characteristic. These stocks in IGM’s portfolio should benefit from several important megatrends in the coming decades. These trends include digital transformation, electric vehicles and autonomous driving, edge and cloud computing, artificial intelligence, etc.

As can be seen from the chart below, semiconductor stocks represent about 23.2% of IGM’s total portfolio. Since these megatrends will enable the need to have more devices with computing capability, a lot of semiconductor chips are required. Therefore, semiconductor stocks in IGM’s portfolio should benefit greatly. The same is true for many software stocks in IGM’s portfolio. As can be seen from the chart, system software and application software stocks represent nearly 29% of IGM’s total portfolio. Megatrends such as artificial intelligence will add a lot of new functions and capabilities to many software applications, and this should enable these software companies to grow their revenues at a rapid pace. Hence, we do foresee IGM to benefit from strong growth in the upcoming decades.

IGM is expensive though

While IGM will benefit from many of these megatrends we named, its valuation is quite rich now. This is especially true following the more than 50% rally since reaching the bottom in late October 2022.

Since there are about 285 stocks in IGM’s portfolio, it will be an arduous task to check the valuations of every stocks in its portfolio to figure out IGM’s average valuation. Fortunately, 84% of IGM’s portfolio are large-cap technology stocks. Therefore, they do have a lot of overlap with the technology stocks in the S&P 500 index. As a result, we can do a quick gauge of the valuation of the technology stocks in the S&P 500 index to see if IGM’s valuation is reasonable or not. As can be seen from the chart below, technology sector’s forward P/E ratio is now at its highest level since reaching the peak during the dot com bubbles. Therefore, we see considerable downside risk based on current valuation.

Source: Yardeni Research

Will there still be more upside?

Given the fact that we are still in a monetary tightening environment, investors should remain cautious. Although the market has been speculating that the Federal Reserve will end its rate hiking cycle very soon and perhaps even lower the rate soon, we do not think this is possible in the near-term especially given the fact that inflation remain well above the Federal Reserve’s long-term target of 2%. If the Federal Reserve acted too quickly to lower the rate, it may cause the inflation to flare up again. In addition, energy prices have been on a rise lately, and this adds more pressure for the Federal Reserve to stand firm on its current monetary policy.

Besides rate hikes, the Federal Reserve has been shrinking its balance sheet as illustrated from the chart below. This means that liquidity will continue to decline and therefore valuations of stocks will continue to be under pressure. Higher valuation sectors such as technology sector will remain under a lot of pressure. Hence, we see a lot of downside risk at the moment.

Investor Takeaway

IGM has a portfolio of mostly large-cap technology stocks that has strong growth characteristics. The fund should also benefit from several important megatrends in the next few decades. However, given its rich valuation and the continual tightening monetary environment, downside risk is high in the near term. Therefore, investors may want to wait on the sidelines.

Additional Disclosure : This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.

For further details see: