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Weighing the pros and cons of the tech sector

Posted on by darion

Additional content provided by Colby Hesson, Research Analyst.

The technology sector was buzzing last week with strong results from beloved artificial intelligence (AI) company NVIDIA (NDVA). Overall, the sector has been the best performer over the last decade, and it is difficult to overestimate the importance of technology to the market. While S&P’s official classification puts the tech sector at around 30% of the S&P 500, adding tech-focused powerhouses like Alphabet (GOOG/L), Amazon (AMZN), Meta (META), Netflix (NFLX), Tesla (TSLA) and others increase this weighting to about 40%.

Big Tech market concentration is approaching “Dot-Com” levels.

A line chart of the market share of technology, media, and telecommunications companies compared to the S&P 500 Index from December 1990 to the present, as described in the previous paragraph.

Source: LPL Research, Bloomberg, 24/05/24

The importance of technology can also be seen in the analysis of earnings. The S&P 500’s first-quarter earnings growth would have been cut by more than half (from nearly 8% to about 3%) if the technology sector was excluded. If we expand the definition of technology to include the biggest names in the tech landscape, including those mentioned above, then technology accounted for all of the S&P 500’s earnings growth in the first quarter.

Not only did technology post solid results last quarter, with earnings growing more than 25%, but estimates for the sector have also increased in recent months.

Estimates of technology gains are rising

A line chart comparing the S&P 500's earnings per share with the technology sector's earnings for the next 12 months, as described in the previous paragraph.

Source: LPL Research, FactSet, 23/05/24
Disclosures: All indices are unmanaged and cannot be directly invested in. Past performance is no guarantee of future results.

The sector continues to grow both revenues and profits at a solid pace, driven by advances in artificial intelligence. Over the past two years, companies in this industry have significantly outperformed broader markets as they, especially NVDA, have demonstrated their ability to scale quickly and capitalize on market opportunities. Artificial intelligence has successfully improved not only technology but everything it requires. Utilities and some segments of the energy sector that are needed to power AI data centers have also seen efficiency gains recently. The industry has even felt the whiff of this wave, with companies building data centers and providing server cooling equipment getting a boost from the AI ​​halo effect.

Favorable technical facilities

Technical indicators for the technology sector are favorable, reflecting strong momentum and positive investor sentiment. The sector has been on a solid uptrend since the current bull market began in October 2022, and in that time it has significantly outperformed the S&P 500. Technical analysis suggests that this positive momentum is likely to continue, at least in the short term.

A technology sector enjoying great dynamics and relative strength

A two-panel chart of the S&P 500 Technology sector showing relative strength and momentum, as described in the previous paragraph.

Source: LPL Research, Bloomberg, 28/05/24
Disclosures: All indices are unmanaged and cannot be directly invested in. Past performance is no guarantee of future results.

Perhaps the biggest concern for tech investors is lofty valuations that raise concerns about the possibility of a correction. While growth prospects remain strong, the sector’s elevated price-to-earnings (P/E) ratio, approximately 30% higher than the S&P 500, suggests that widespread earnings shortfalls or macroeconomic disruptions could potentially trigger excessive price declines relative to the index. Expectations for future earnings are currently high, leaving little margin for error. In the past, technology has been highly valued for breakthrough innovations, as was the case in the 1990s, and it can be difficult to put a price on such enormous future opportunities. What seems certain is that investment in AI is significant, and the benefits are likely to be as well over time.

Technology valuations are elevated, but well below tech bubble levels

A line chart of price-to-earnings over the next 12 months versus the S&P 500 from 2000 to 20024, as described in the previous paragraph.

Source: LPL Research, FactSet, 23/05/24
Disclosures: All indices are unmanaged and cannot be directly invested in. Past performance is no guarantee of future results.

Given strong returns, booming AI developments and technical momentum, technology is a sector where we believe it makes sense to maintain significant exposure (it is the largest sector on the S&P 500 Index). However, elevated valuations and the concentration of a few large-cap leaders increase the potential for volatility and the potential for market rotation. Given this mix of pros and cons, LPL Research’s Strategic and Tactical Asset Allocation Committee (STAAC) currently recommends a neutral allocation for technology, although it is one of our favorite neutral sectors, alongside industrials, and one that we could potentially improve in case of weakness, depending on the macro environment.