So far this year, tech stocks have had a good run. The (ticker: XLK) has gained 14.8% year to date, outperforming the 12.9% rally.
But that follows a rough fourth quarter. The Technology Select ETF plunged 23.3%–a substantial underperformance–as the fell 15.8% from peak to trough between Sep. 20 and Dec. 24.
Tech stocks could soon be lagging behind the market again.
So-called high-beta stocks such as tech–those that are more volatile than the overall market–are likely to be vulnerable when the current rally starts to run out of steam later this year, Morgan Stanley analyst Michael Wilson said in a research note on Monday.
That’s because in the late phase of an economic cycle, growth-oriented companies tend to pull back from investing heavily in their businesses, choosing to be conservative with their spending. That’s happening now, a shift that has sent growth in tech firms’ capital spending down to 6.5% from 24.5% in the first quarter of 2018, Wilson said.
He expects the decline to continue.
Reduced capital investment, along with weaker consumer spending, has dragged on revenue growth in the tech sector, even as a tight job market has boosted labor costs, compressing tech companies’ profit margins.
Over the past few years, tech companies have been the largest contributor to earnings growth within the S&P 500, but that has changed recently. The tech sector now ranks in the middle among contributors to profit growth, Wilson says.
This year, aggregate earnings for tech companies are expected to fall 1.8%. The picture could be even darker because estimated earnings are usually scaled back as the time for results to be released approaches, he says.
And despite the bleak outlook for growth, tech stocks’ valuations are still at a historically high level compared with other sectors. Software companies, especially, are 40% more expensive than other stocks in the S&P 500.
Given that the economy is past its peak and the flurry of spending that followed the Trump tax cuts is behind us, Wilson says, the sector’s valuation is dangerously high. It shouldn’t stay elevated for long, he argues.
Multiple challenges lie ahead, wrote Wilson. Members of Congress including Chuck Schumer, Bernie Sanders and Marco Rubio have been proposing rule changes that could require companies repurchasing stock to meet minimum requirements for employee benefits, as well as raising the tax rate on capital gains. If the legislation were to pass, tech companies’ buybacks, which accounted for one-fourth of the total buybacks of S&P 500 companies from 2011 to 2018, could come under pressure.
Tech companies have also been caught up in the U.S.-China trade war. Many have high sales exposure to the Chinese market, as well as connections with Chinese companies and capital markets on multiple levels.
Congress’s increasing focus on data privacy could also lead to policies that might constrain tech companies’ revenue streams, Wilson says.
Still, he sees opportunities, offering a list of stocks that both ranked high on a Morgan Stanley quantitative model and were rated Overweight by analysts. The potential winners include Apple (AAPL), Genpact (G), Mastercard (MA),Microsoft (MSFT), and Paypal (PYPL).
The Invesco QQQ Trust Series 1 (QQQ) was trading at $173.77 per share on Tuesday morning, up $0.25 (+0.14%). Year-to-date, QQQ has gained 11.74%, versus a 5.30% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of MarketWatch.