Have we just seen the first hints of a market rotation away from tech and go-go growth and back to value stocks? Nvidia’s (NVDA:NASDAQ) recent 13% three-day share price decline was newsworthy as it knocked $429 billion off its market valuation. Look beyond the headlines and you will see something else interesting bubbling under the surface.

It is impossible to draw any firm conclusions from such a short trading period, but what happened over the three trading days to 24 June 2024 is worth bearing in mind if we get a full-blown market correction in the future. It provided a shop window into where investors might switch investments if there is a change in sentiment.

The worst-performing shares during this period were highly rated growth style companies and the best performers were lowly-rated value ones.

Looking at the S&P 500 index of US shares, the average price to earnings or PE ratio for the top 20 fallers was 37.7 during the period where Nvidia slumped, a level that classifies as a premium rating. The average PE for the top 20 risers was 14.5 which is a cheap rating.

Technology shares dominated the sell-off, while the risers included a media group, a fertiliser producer and an agribusiness specialist.

In the UK, it is also notable that classic value style stocks in the tobacco and supermarket sectors have started to perk up on the market in recent months.

Investors are often less willing to hold highly rated shares during a market downturn, for fear they could de-rate. Put another way, investors are less willing to pay higher multiples of earnings when markets are going through a bad patch.

Value or lowly rated shares tend to shine in tougher market conditions as investors look for cheap stocks that offer jam today, rather than more expensive ones that offer the prospect of jam tomorrow.

Tech has been a wonderful place to make money over the past few years but shares rarely travel in a straight line so you have to be slightly nervous when they keep rising, which is the current situation. Certain big tech names are looking expensive – the higher their shares climb, the bigger the potential fall if markets turn.

IMPORTANCE OF FUNDAMENTALS

The key thing to watch is whether a company’s fundamentals justify its share price rise. Nvidia has beaten expectations for the last six quarters in a row.

Earnings growth has been strong and so analysts have had to upgrade forecasts following each of these six quarters and that created back-to-back catalysts to sustain the share price growth. In this case, the fundamentals have supported the stock’s high valuation.

Nvidia will publish its next set of quarterly results in August and failure to beat expectations might cause the share price to wobble. No-one knows for certain what will happen to the share price, but history suggests stocks in its situation might behave this way.

A LESSON FROM GREGGS

For example, shares in food retailer Greggs (GRG) fell 12% on 1 October 2019 when it published what initially felt like a solid trading update. A quick look closer and the reason behind the big share price decline was obvious.

Three things had fuelled Greggs’ shares over the preceding 12 months: earnings upgrades, investors happy to pay a higher rating for the stock and the company being one of the few ways for UK investors to play the fast-growing vegan theme. The business has historically traded in a PE range of 16 to 25 but Greggs’ valuation exceeded 35-times during 2019 amid euphoria around its growth prospects.

Greggs continued to report strong trading as 2019 progressed and that led to more upgrades from analysts as they raised their future earnings estimates. The music then stopped and so did the share price gains.

With the October 2019 trading update, everything was riding on the company once again beating expectations and Greggs saying there was still big interest in its vegan products. Sadly, neither happened and the shares quickly de-rated as investors were no longer prepared to pay a high earnings multiple to own a slice of the company.

This illustrates what could potentially happen with Nvidia when it stops beating expectations with quarterly results. That would be negative for its share price and the wider market.

Nvidia’s stellar share price gains since the start of 2023 have made it one of the most closely-watched stocks on the market – if it falls, sentiment might turn and have a knock-on impact on the wider market.

‘THE SHIFT COULD BE DRAMATIC’

In March, analysts at Stifel wrote: ‘The Magnificent Seven collectively doubling in value last year has been an important driver of returns for global, tech and US equity trusts. We are always wary of the consensus view and potential bubbles and think when the Magnificent Seven move out of favour, the shift could be dramatic.’

‘Magnificent Seven’ is a term used to describe seven mega-cap tech-related names: Nvidia, Microsoft (MSFT:NASDAQ), Apple (AAPL:NASDAQ), Amazon (AMZN:NASDAQ), Alphabet (GOOG:NASDAQ), Meta (META:NASDAQ) and Tesla (TSLA:NASDAQ). A sell-off in any of these names could lead to volatility in the market, but Nvidia and Microsoft are the ones to watch closest because they are the biggest names in the group.

It is important not to be alarmist, but all investors must think about how markets behave and history suggests they regularly go through cycles. At some point – and we have no idea when – the current wave of go-go growth tech stocks will find it harder to keep rising. Thinking about what to do with portfolios in advance of that situation could be advantageous as it feels safe to say it is a question of ‘when’ and not ‘if’.

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