Earnings season has only just started, but investors who thought it would begin with a bang got a whimper instead.
Tesla (TSLA 5.34%) and Netflix (NFLX 1.84%) both posted disappointing quarterly results on Wednesday, sending the Nasdaq into a tailspin the following day as the tech-heavy index lost more than 2% and the Nasdaq 100 had its worst performance in five months.
The sell-off came even as the Dow Jones Industrial Average gained 0.4%, showing the retreat was largely isolated to the tech sector. Weak reports from both Tesla and Netflix, whose shares have surged this year, seemed to convince investors that the sector has become overvalued, with the Nasdaq already up 34% year to date on excitement about AI and hopes that an economic recovery will support a rebound in tech stocks after last year's bludgeoning.
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Did Tesla and Netflix just give investors a warning?
Tesla and Netflix are two of the most closely watched stocks on the market and two of the best-performing stocks over the last decade and beyond thanks to successfully disrupting their respective industries.
Tesla shares pulled back in spite of beating estimates on the top and bottom lines after the company reported another round of declining gross margins, showing that it is struggling to maintain its pricing power as the electric vehicle market grows more competitive.
Netflix, meanwhile, continues to experience sluggish revenue growth even though the company posted a strong bump in subscribers. It added 5.9 million new members in the second quarter, in part because of its new paid sharing program, its response to password sharing. Additionally, Netflix said that revenue from advertising is not yet material, which may also have disappointed investors.
Both stocks seemed to fall because of valuation concerns rather than lackluster quarterly results as both stocks got expensive after their recent run-ups.
Netflix stock now trades at a price-to-earnings (P/E) ratio of 46, and its revenue grew just 3% in the second quarter.
Tesla, meanwhile, carries a P/E ratio of 78, a valuation that seems to bake in a lot of growth potential beyond its auto business, including robotaxis, artificial intelligence, its charging network, and energy storage products.
Stretched valuations leave little room for error when quarterly reports come due, so it's not surprising that both stocks sold off on the results.
Is this a new bull market or a bear market rally?
It's important for investors to recognize that Tesla and Netflix aren't bellwethers for the economy, the stock market, or even the tech sector.
These are industry leaders whose performance has little bearing on the competitive landscape in other industries, but there is a lesson that investors should pay attention to here.
The surge in tech stocks this year has been based on anticipation of a rebound, rather than a meaningful improvement in fundamentals, which means it would be easy for the rally to unravel.
Take a look at how the P/E ratios of big tech stocks like Apple, Microsoft, and Alphabet have expanded this year too.
Data by YCharts.
As you can see, valuations for these three stocks are up by about 50% so far this year, and forward P/E ratios have also expanded significantly even as these three stocks have posted sluggish growth numbers in recent quarters.
These stocks will have to start delivering improving results in order to justify their recent gains and continue marching higher.
The market reaction to the Tesla and Netflix reports shouldn't spook investors, but it's likely a sign that the recent surge in tech stocks has run its course until fundamentals can justify additional gains. We'll learn more next week when big tech stocks like Apple, Microsoft, and Alphabet also report earnings.
