Technology—Too Far or Room to Run?

by Brad Sorensen, CFA, Managing Director of Market and Sector Analysis, Schwab Center for Financial Research

The technology sector has been on a remarkable run. It was the best-performing sector over the past three- and 12-month periods, as well as the best year-to-date performer—and it really isn’t all that close. The tech sector now accounts for 23% of the S&P 500^® Index—up from 15% in 2008—marking its heaviest waiting on the benchmark index since the tech bubble in 1999.

Tech accounts for a larger share of the market

After a run like that, it makes sense that investors are asking if tech may have gone too far. Could a retrenchment be in store? Some might even be wondering if we’re at risk of repeating the collapse that started in 2000, when tech saw its weighting fall from 33% of the S&P 500 to 14% a mere three years later. It’s certainly appropriate to be on alert for potential bubbles forming, and maintaining a properly diversified portfolio means making sure that no single position grows to occupy an inappropriately large share of your portfolio, but at this point we believe the tech sector still has more room to run. That doesn’t mean that there won’t be pullbacks, and occasional dips would likely be healthy, but the overall environment still looks positive to us—and much different than the bubble period of the ‘90’s.

Should tech make up such a large percentage of the S&P 500? We don’t know what the “right” percentage is, but we believe indexes ideally should reflect what is going on in the overall economy. And at this point it’s tough for us to argue that technology-related products and services don’t make up at least a quarter of the U.S. economy. To back that up, it should be noted that according to Yardeni Research, the tech sector’s share of S&P 500 earnings—at 22%—aren’t much below the current weighting of 23%. Compare that with the height of the tech bubble, when tech’s share of earnings was j 15%, while its weighting was more than 30%. Even areas that don’t readily come to mind as being tech-related, such as energy or health care, perhaps, are increasingly appearing to turn to tech to enhance their business operations.

Concerns about valuations and the size of certain heavyweight companies often come up as well. People often mention the so-called FANG stocks—Facebook, Apple, Netflix and Google (now Alphabet)—in this context, but it’s useful to remember that the A and the N in FANG are not part of the tech sector. They are actually part of the consumer discretionary sector.

In any case, should we be concerned about valuations? Ned Davis Research (NDR) data show that the tech sector has a forward price-to-earnings ratio of between 18 and 19. That’s slightly below the sector’s 30-year average of 19.9. Of course, that period includes the tech bubble, when high valuations also skewed the average higher. All things considered, we think that means valuations are roughly in line with historical averages—presenting neither a compelling buy or sell case.

The NDR data suggest valuations also haven’t tended to be a good gauge for determining when outperformance will end. Areas of the market can stay overvalued or undervalued based on traditional measures for quite some time. Valuations do a better job of predicting longer-term performance, because returns eventually tend to return to the mean.

Further muddying the picture is that the tech sector is much different today than it was in the late ‘90s. We don’t have the space to get into all the differences, but one of the best ways we can describe it is by looking at the sector’s composition. Sectors are often characterized as defensive or cyclical based on their sensitivity to economic conditions. That applies within sectors as well. Tech has historically been thought of as a cyclical sector, and for good reason: More cyclical stocks made up roughly 80% of the sector in 2000, according to Cornerstone Macro Research. That share has decreased to slightly less than 50% today, meaning the tech sector is now as much a defensive sector as a cyclical one. That could help explain its stability now.

Regarding the issue of a few heavyweights, we aren’t that concerned at this point, but it is something to watch. This shouldn’t be construed as an opinion on any of the four stocks mentioned, either positive or negative, but when an individual security starts to make up more of an index, it certainly warrants watching. For example, Apple makes up about 17% of the S&P 500 tech index, according to Strategas Research Partners, while Google (Alphabet) makes up about 12%.

However, it’s worth noting that the sector’s recent gains have been pretty broad-based. According to Evercore ISI Research, the tech sector was up roughly 20% through the end of May, with a median return of almost 19%.  While past performance does not guarantee future results, almost 75% of the sector’s stocks have outperformed the S&P 500.

So, we don’t see signs of an imminent downturn—but we do see some other positive signs. As noted, more and more companies appear to us to be turning to tech solutions to improve their businesses. And with unemployment reaching historically low levels, it is our view that tech is increasingly going to have to be used to do work that humans are unable or unwilling to do. And on the consumer side, more people working should mean more money available to spend on the latest tech gear.

Low unemployment should help tech

And we are starting to see signs that businesses are opening their pocketbooks with regard to capital expenditures. As seen below, we are seeing good indications that non-residential fixed investment is improving, which, according to data compiled by Strategas, has been a strong indication of improving tech revenue growth.

Non-residential investment looks to improve

Finally, in the fog of all the news coming out of Washington, it can be easy to lose track of what’s going on, but we continue to believe there could be an additional tailwind from some sort of repatriation deal for corporate earnings held overseas, which is one area where there seems to be at least some agreement. Again according to Strategas, tech companies have the largest amount of cash overseas, and if they could bring that back at a reduced tax rate, we believe the companies would benefit.

The tech run likely won’t go on forever—nothing does—but we don’t see the unabashed enthusiasm for the group that would make us more concerned, and valuations aren’t extended to the point that we believe investors should start to worry. That doesn’t mean investors who have developed too large a position in tech relative to their risk tolerances shouldn’t rebalance and take some profits. But we continue to see positive developments and believe the run in the tech sector still has further to go.

Copyright © Schwab Center for Financial Research