Published November 19, 2021
Here at TimingCube we are focused on the Nasdaq 100 index, trading with the symbol QQQ. This index typically contains the most innovative and “high tech” companies in the stock market with a strong bent toward technology and consumer services. Schwab recently posted an article outlining the pros and cons of the broad tech sector, which has a very high correlation to the QQQ. We thought you might find it interesting. Here is Schwab’s tech sector analysis:
“Rarely is there any sector that has everything going for or against it—and that is true today of the Information Technology sector. What’s to like? It boasts impressive profitability—the best across all 11 S&P sectors; it’s positioned well if economic growth continues—even at a slower pace; and it has compelling fundamental underpinnings, as inflating input and labor costs are spurring businesses to accelerate investment in productivity-enhancing technologies.
But there also things to dislike about the sector. It is highly concentrated in just a few stocks, valuations are sky-high by almost all measures, and higher interest rates—all things equal—could make them even less attractive. We’re neutral on the sector now.
What’s to like
Strong profitability: One of the most important considerations for any sector is its fundamentals—the short- and long-term drivers for revenues and profits. A good yardstick of fundamental strength is return on equity (ROE), which measures how efficiently companies within a sector generate profits relative to shareholders’ equity. The Technology sector has the highest ROE of all sectors, as well as relative to its own historical average; and upward revisions to its expected earnings over the next year have been among the strongest of any sector.
The Technology sector has solid fundamentals
Source: Charles Schwab, Bloomberg. Calendar year 2022 Bloomberg estimated Return on Equity and 3-month percent change in earnings per share for each of the S&P 500 Index sectors. As of 11/12/2021.
Rising capital expenditures: Even amid the offshoring of much technological innovation and production in the past several decades, business investment in information processing, software, and industrial equipment in the United States has increased significantly. The Technology sector continues to play a pivotal role in advances in robotics and automation; the transformation toward big data and cloud computing; the software and artificial intelligence that make it work; and smartphones, tablets, and network interfaces that enable us to use it. In the wake of the COVID-19 pandemic, higher wages, labor shortages and input inflation has resulted in an acceleration in investment in productivity—and labor-enhancing technologies. While there is some concern that the current surge in semiconductor production could result in oversupply when high demand is satiated, plans for more rapid spending on cost-saving technologies could help sustain demand for chips. We believe that strong trends in capital spending will continue and—if history is a guide—could coincide with outperformance of the Technology sector, as illustrated in the chart below.
Higher capital expenditures have led to better performance of the Technology sector
Source: Charles Schwab, Bloomberg. Bureau of Economic Analysis data on Private Fixed Investment Nonresidential Information Processing Equipment, Nonresidential Intellectual Property Products, and Investment Industrial Equipment. Blue line is the difference of the quarterly annualize sum of these data from the 10-year moving average of the sum. Light red area represents the ratio of price returns of the S&P 500 Technology sector to the S&P 500 Index. As of 11/12/2021. Past performance is no guarantee of future results.
Cyclical growth characteristics: We think we’ve seen a peak in the rate of economic growth, though we expect it to continue at a slower pace—consistent with a maturing expansion phase of the economic cycle. Historically, the Technology sector has had its strongest outperformance on the tail end of recessions and into recoveries—as was the case in 2020 emerging from the COVID-19 recession. Growth stocks—many of which are in the Technology sector—also tend to perform well as economic expansions mature, as investors search for stocks with ongoing profit growth potential amid peaking earnings growth for the market overall. Additionally, the sector has historically outperformed the overall market on average in the 12 months prior to the Federal Reserve’s first hike in the federal funds rate.
The Technology sector has tended to outperform before a first rate hike
Source: Charles Schwab, Ned Davis Research with permission. The average performance of the S&P 500 Technology sector relative to the S&P 500 Index 12 months before and after the first increase in the Federal Reserve Bank’s federal funds target rate in the past five rate-hike cycles, as identified by Ned Davis Research. As of 11/12/2021. Past performance is no guarantee of future results.
What’s to dislike
High valuations: Strong profitability and prospects for continued earnings growth, cyclical tailwinds, and trends in technology capital expenditures have been contributors to the outperformance of the sector in recent years. However, this has driven valuations by most measures well above their historical norms, except when they are considered in the context of the currently very low level of interest rates. A lower interest rate (a.k.a. discount rate) makes the value of future cash flows (i.e. earnings paid as dividends) worth more today. Taking that into account, the Technology sector appears to be fairly valued.
Here’s the rub. With inflation sharply higher and the Federal Reserve having embarked on the unwinding of its monetary stimulus, higher interest rates pose a significant though surmountable risk, in our opinion. We think that the 10-year Treasury yield could rise to 2% or higher in 2022, which may be a short-term headwind to the sector. Sectors with the highest valuation multiples—like Technology—could be the most at risk, particularly if the overall market reacts negatively to higher rates.
The sectors with high valuations are at risk from higher rates
Source: Charles Schwab, Bloomberg. Bloomberg estimated price/earnings ratios for 2022. As of 11/15/2021.
Highly concentrated: While the Technology sector has 75 companies across six industries, just three stocks—Apple, Microsoft, and NVIDIA—account for nearly 50% of the sector’s market cap. As such, if you get the call on those stocks wrong, then you can get the whole sector wrong.
Putting it all together
We think that the fundamental and cyclical underpinnings of the Technology sector will prevail over the intermediate term. In our opinion, the strong trend in capital expenditures on productivity enhancing technologies will continue to support robust profitability, and the maturing phase of the business cyclical is favorable to the growth-oriented sector. Expectations for a rise in interest rates could be a short-term headwind for richly valued technology stocks.
However, if economic growth continues and inflation pressures eventually ease—as we think they will—a further rise in interest rates could reflect investor optimism in the economy, which is typically good for the Technology sector.”
Market Update
Stocks traded tightly to begin the week ending unchanged in Monday’s trade. Chicken processor Tyson Foods (TSN) exemplified one of the major themes of this earnings reporting season as the company said they have been able to raise prices to offset increased costs. Tuesday brought a solid retail sales report as well as good earnings from top retailers Walmart (WMT) and Home Depot (HD) leaving stock indexes higher by +0.4%. Retailer earnings continued Wednesday with largely strong reports. However, stocks lost ground as oil prices slumped amid concerns that rising Covid-19 cases in Europe will slow global economic growth. The -0.3% dip Wednesday was exactly reversed Thursday. Earnings from department store owners Kohls (KSS) and Macy’s (M) combined with a record setting report from chipmaker Nvidia (NVDA) to boost investor enthusiasm. However, slumping oil prices and a downdraft in interest rates hurt energy and financial shares Friday offsetting strength in Apple (AAPL) to leave the broad market indexes off -0.1%. Apple firmed up plans this week to launch an electric vehicle, feeding into that super-hot market theme.
Stocks were mixed this week as strength in large-cap tech shares boosted the Nasdaq 100 (QQQ) by +2.35% while more cyclically-dependent smallcap shares (IWM) swooned -2.83%. The S&P 500 (SPY) reflected the split market with a very slender +0.35% move.
Warm wishes and until next week.