Tech is no longer the leading performer in the US stock market. Amid the almost euphoric start to the year for global equities, it might be easy to overlook a change that could yet shape the tenth year of the bull market.
In the US, industrials, consumer discretionary and materials, whose fortunes are all closely tied to the strength of the American economy, have this week outshone a sector that trounced everything else in 2017.
The tax cuts signed into law by Donald Trump will pose a challenge to the tech sector’s market dominance this year if the US economy finds a higher gear and polishes the profits and revenues of those sectors most sensitive to faster growth. Given the tech sector also pays a lower effective tax rate than others, it has less to gain from the reduction in the corporate tax from 35 per cent to 21 per cent.
Some investors have not wasted any time. Michael Underhill, chief investment officer at Capital Innovations, late last year downgraded the tech sector to neutral from overweight in favour of sectors such as financials and industrial shares, which he sees as being bigger beneficiaries from tax reform.
“The tech sector’s low effective tax rate (19 per cent versus 26 per cent for the S&P 500) means it has little to gain from tax reform,” he says.
Given the sheer dominance of the tech sector last year — its 37 per cent gain was almost double that of the wider S&P 500 — it is easy to forget that over the past 18 months it has had periods on the back foot when hopes for the reflation trade have been at their most intense.
The two-month period, for example, between Mr Trump’s election and the end of 2016 was marked by fevered expectations that a Republican-controlled Congress and White House would take US growth above 3 per cent and lead to higher inflation. During that period, the tech sector gained just 1.1 per cent versus 16.5 per cent for financials, 7 per cent for industrials and 5.4 per cent for materials.
But if some believe a more buoyant US economy will make investors less willing to pay a premium for the revenue growth and profit growth that the tech sector — and particularly behemoths such as Facebook, Apple, Netflix, Alphabet and Microsoft — generate, others voice caution about writing off the possibility that tech will once again end the year at least among the stock market’s best performers.
Despite underperforming for the first two weeks of the year, the sector has plenty of tailwinds and the consensus among investors remains upbeat. And its performance matters. The tech sector is the S&P 500’s largest at almost 24 per cent of the index, so any declines for tech present a significant hurdle for a rise in the overall index, which many strategists and investors predict for 2018.
“It is business performance” that has been driving tech stocks, says Jonathan Golub, Credit Suisse’s chief US equities strategist.
Behind the 2017 gains for tech was profit growth that repeatedly outpaced that of the broader market. In the third quarter, for example, tech earnings jumped 20 per cent per share from a year ago while the aggregate number for the index was just 6.4 per cent, FactSet data show.
Wall Street analysts expect the tech sector to stand out again in fourth-quarter earnings season, which begins this month. Tech companies are forecast to report earnings growth of 16 per cent and revenue growth of 11 per cent compared with 10.2 per cent and 6.8 per cent for the S&P 500, respectively. But other sectors, such as energy and materials, are forecast for better growth.
Despite the eye-catching gains for tech, valuations for the sector are not at a record high. Number-crunching at Credit Suisse, which includes internet retailers in tech versus the official S&P 500 category breakdown which slots them to the consumer discretionary sector, puts tech trading at 19.5 times forward earnings versus 18.1 for the S&P 500. By contrast during the dotcom bubble at the end of 1999, tech traded at 44.5 times versus 24.3 times for the broader index.
“When you think about the world today, where is the growth coming from?” says Michael Lippert, a portfolio manager at Baron Capital. “It is coming from this massive generational shift globally that is going to all things digital.”
But the outsized role that a handful of companies such as Facebook and Amazon are playing in that shift brings its own risks, including the threat of a regulatory backlash, some investors say.
“If the regulatory framework shifts from financial to technology companies that could be a risk whether from the European Union or the US government,” says Michael Arone, chief investment strategist at State Street Global Advisors. “The idea being that tech has become too big and too influential and in need of being regulated further or broken up to deal with risks they cause given their perceived influence on events — elections being one of them.”
If that is a simmering threat — and not Mr Arone’s base case scenario — a more immediate challenge for the sector is whether its biggest players can meet Wall Street’s high expectations for the fourth quarter. Any disappointments and investors expect tech stocks to be punished and possibly severely so.
Combine that with the current optimism around the implications of the tax cuts, and the high-flying tech sector risks further underperformance in January. But we are still in the first month of the year and any “policy driven weakness” might be seen as a buying opportunity, says Mr Underhill of Capital Innovations.