On the 7th of March, I wrote an article on the SPY ETF (SPY), titled: “S&P500: Negative Sentiment Got Extreme, Prepare For Lasting Rebound”. In my opinion, previous week we saw the impulsive beginning of that rebound. As there is a considerable Wall of Worry for markets to climb in the form of the high inflation – rising interest rate environment – recession fears triumvirate, this rebound could be a bumpy, but a prolonged one.
Although we are in an increasing rate environment, I think the technology sector could outperform most others during this period, so now it’s a good time to increase the weight of technology-related assets (e.g.: Invesco QQQ ETF (NASDAQ:QQQ)) in portfolios. In the following, I will discuss the main reasons behind this thesis and highlight the main risk factors to it at the end.
The damage to the technology sector is done
The new Bank of America Fund Manager survey came out this week underpinning the fact that investors got extremely cautious at the beginning of the month. Cash levels shut up to 5.9%, an extreme level, which proved a very good contrarian signal for stocks in the past:
In these times of extreme fear, the technology sector became the most feared one in my opinion. This can be evidenced also in the Bank of America Fund Manager survey, which showed that fund managers became net underweight tech in February for the very first time since the GFC:
As currently tech fundamentals are still very healthy and valuations came down to more reasonable levels (with some exceptions), I think this period of under-allocation will fade quickly, just like it did back in 2009.
One important difference in allocations compared to 2020 April is that back then fund manager’s net allocation towards stocks in general was strongly underweight. Currently net allocation towards stocks is still positive, which means that this time there is probably less buying power out there. I think this shouldn’t hinder the rebound but could result in a slower one.
However, in the case of technology stocks the situation is different due to the rarely seen net underweight position. I think this should result in a stronger comeback, providing one of my reasons why the sector could outperform in the months ahead.
Rising rates don’t equal falling technology stock prices
One popular view among investors is that in a rising interest rate environment, technology stocks tend to perform bad. It is true that discounting future cash flows with a higher discount rate hurts these companies’ valuations, but the market usually prices this in within a short period of time.
In the graph below, I’ve highlighted those periods where the U.S. 10-year yield (left scale, purple line) showed a significant increase in the past, and compared it with the Nasdaq Composite index (COMP.IND) (right scale, blue line):
If we look at the different periods, we can see that the Nasdaq managed to increase in these rising rate environments. One notable exception to this is the current stock market correction, but I wouldn’t judge too soon. I think it is real possibility that rates, and the Nasdaq rise further hand in hand, just like they did in previous instances. In my opinion, the main condition for this is that we escape a deep recession this year or next and face a period of higher inflation and medium/slow growth instead.
Technology stocks should hold up well in times of stagflation
The combination of higher than usual inflation and below average economic growth is usually referred to as stagflation, although Iain Macleod, British Conservative Party politician used it originally to describe the combination of high inflation and unemployment. The latter combination is the more fearful one, as raising the Fed funds rate in a high unemployment environment could increase the risk of a recession significantly. Currently, we do not face this issue as evidenced by the 3.8% U.S. unemployment rate, and the low level of initial jobless claims, a good leading indicator for unemployment:
This shows that currently we must deal with the less harmful version of stagflation if we can speak about stagflation at all. Without getting carried away by the different definitions of stagflation, it is worth to note that based on the Fed’s most recent economic projections, 2022 real GDP growth should be still 2.8%, significantly above the 1.8% longer run expectation:
Although this is coupled with an inflation forecast for 2022 of 4.3%, this combination shouldn’t be catastrophic for investors at all.
I think that in such an environment, companies with good pricing power should perform well, especially those ones who are not exposed to the sharp rise in raw material and energy prices. Most companies in the technology sector fulfill these criteria. On top of that, if growth expectations continue to fall, companies with higher growth profiles could come to the fore even more. This could be also a tailwind for the technology sector.
Technology stocks could shield from pandemic-related risks
At this point, I want to add another potential tailwind that could benefit the technology sector, which is the possible recurrence of Covid. I truly hope that it won’t come to that, but if we were to face renewed rounds of serious Covid outbreaks leading to economic lockdowns, these would favor the technology sector as well. After the initial panic selling, it took the Nasdaq 100 (NDX) 54 trading days to recover to pre-pandemic highs in 2020, while the same took 107 days for S&P 500 (SPX).
Sold the rumors, buy the news
One of the most well-known conventional wisdoms in the stock market goes: Buy the rumor, sell the news. As this time, there were bad rumors that the Fed will raise interest rates due to stubbornly high inflation, so the correct saying for technology stocks could have been: Sell the rumor, buy the news.
With the 9th March Fed meeting the news are out. The central bank revealed that it intends to raise rates another 6 times this year, and 3-4 times again next year to achieve a Fed funds rate of 2.8% until the end of 2023:
With this, uncertainty, one of the worst enemies for stocks, has diminished on the Fed front for a while. I think this also favors an uptrend in stocks, which could be more pronounced in the technology sector.
Strong fundamentals supporting bullish stance
The S&P 500 technology sector capped a strong year in Q4 2021 with earnings rising 22.7% YoY. Although this strong performance was partly due to a somewhat lower than usual base in Q4 2020, earnings are expected to grow further in 2022 by 12.3%. The trend of EPS estimate revisions in the sector has been positive so far this year, as of the end of 2021 analysts predicted “only” a YoY increase in EPS of 10%, which increased to 12.3% since then.
With this continuous strong performance, the sector remained the most profitable one among the 11 different sectors of the S&P 500, with a trailing 4-quarter operating profit margin of 23.2% in Q4, almost 80% higher than that of the S&P 500 overall. The graph below by Yardeni Research provides a good illustration for this, where the actual profit margins of different sectors (red lines) are compared to that of the S&P 500 (dotted, blue lines):
One of the main factors behind strong technology fundamentals is the increasing adoption of cloud services. The cloud segment is a really important driver behind the earnings of Amazon (AMZN), Alphabet (GOOG) (GOOGL) and Microsoft (MSFT), which make up currently 25% of the weight of the Nasdaq 100 Index. The Q4 2021 earnings season showed that cloud revenues are still holding up very well, providing continued tailwind to these companies:
On top of that, there are also many other smaller companies in the Nasdaq 100 whose businesses are heavily dependent on cloud adoption (e.g.: Workday (WDAY), CrowdStrike (CRWD), Zscaler (ZS), Datadog (DDOG), Splunk (SPLK), etc.), so increasing cloud revenues at the big three have a far-reaching positive effect.
Valuation multiples at more reasonable levels
With the simultaneous correction in technology stocks and positive earnings revisions for 2022, the valuation of the IT sector came down to a more reasonable level:
The forward P/E ratio of the S&P 500 IT sector decreased back to 22.7 (green line), which is still somewhat above pre-pandemic levels, but significantly lower than during the second half of 2020 and during 2021.
If we look at the growth adjusted PEG ratio (red line), which takes long-term growth prospects for the sector into consideration, we can see that we are not that far from levels observed during the past ten years. This shows that higher than average valuations for the IT sector in recent years are partially explained by the fact that longer-term growth prospects for many of these companies became much stronger, for which investors are willing to pay a higher multiple.
This can be evidenced by the relative forward P/E ratio of the IT sector and that of the S&P 500 (blue line), which shows a continuous increasing tendency in the past decade. Currently, the IT sector is valued at 1.2x the S&P 500 index, although the ratio back in 2017 was only around 1.
Based on the above, I think that until the fundamental picture in the technology sector remains so strong, a premium valuation multiple will be justified compared to both historical averages and the S&P 500.
No signs of recession on the horizon
I think the main risk factor to increasing bets on the technology sector could be a recession occurring this year or next. This would lead companies to postpone investments into new technologies just like they did it during Q2 and Q3 2020. Currently, leading economic indicators don’t indicate this kind of threat.
If we look at J.P. Morgan’s Global Composite PMI, we can see a bounce in February to 53.4 from January’s one-and-a-half year low of 51.4:
If we look at the manufacturing and services PMIs of the U.S., the general economic picture is even better there, with both indices far above 50, the critical value separating growth and contraction. Further good news is that after a longer period of slowing growth, there was an uptick in February in both indices:
The Russian invasion of Ukraine will probably lead to some deterioration in PMIs in March, especially in Europe, but I don’t think this would be a turning point for the global economic recovery. Perhaps a larger threat to this could be the renewed spread of Covid in China already resulting in widespread lockdowns. This could increase the pressure on global supply chains again, leading to an even more prolonged high inflationary environment, which is already fueled by higher energy prices since the Russian invasion.
If inflation would really get out of control leading central banks to tighten monetary policy even faster in a slowing growth environment, this could increase the risk of a recession materially. As I have shown above, currently we are far from that point, but this is an important risk factor to watch out for.
Besides PMIs or initial jobless claims already discussed previously, high bond default rates are also reliable leading indicators, which are worth the follow closely in the current environment. As of the end of February, high yield bond default rates in the U.S. tracked around 0.3% (blue line), close to historic lows. If we would experience a material uptick here, it would give reason for caution.
Conclusion – Climbing the Wall of Worry
Currently, we are in a somewhat fragile economic environment, which has scared investors and led them to reduce their exposure towards technology stocks to levels not seen for many years. In the meantime, IT sector fundamentals are still very strong, and the general economic outlook isn’t that bleak as well. This tells me that now it’s a good time to increase exposure towards the tech sector.
In my opinion, recent market turbulence will calm down soon, and investors will begin to realize that at current levels the technology sector offers great value. However, as long as there are lot of negative news out there (Russian invasion of Ukraine, stubbornly high inflation, Covid, etc.), these will act as a Wall of Worry, leading to a just gradual increase in risk appetite. I think this will be good for markets, because it will take lot of time until we reach levels of extreme optimism again, like we did during the first half of 2021.
The main risk to this thesis would be a potentially forthcoming global recession, which I think has a really low possibility at this point. However, I suggest looking out for leading economic indicators regularly until there are several uncertain factors in the economy out there.