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. We’re currently neutral on the sector as we assess the reaction to higher interest rates, but continued relative strength and seasonal tailwinds at the start of the year could tip the scales in favor of the sector.
What do the ratings mean?
The sectors we analyze are from the widely recognized Global Industry Classification Standard (GICS®) groupings. After a review of risks and opportunities, we give each stock sector one of the following ratings:
- Outperform: likely to perform better than the broader stock market*
- Underperform: likely to perform worse than the broader stock market*
- Neutral: no current view on likely relative performance
* As represented by the S&P 500 index
Want to learn more about a specific sector? Click on a link below for more information or visit Schwab Sector Views to see how they compare. Schwab clients can log in to see our top-rated stocks in each sector.
How should I use Schwab Sector Views?
Investors should generally be well-diversified across all stock market sectors. You can use the Standard & Poor's 500® Index allocations to each sector, listed in the chart above, as a guideline.
Investors who want to make tactical shifts in their portfolios can use Schwab Sector Views' outperform, underperform and neutral ratings as a resource. These ratings can be helpful in evaluating and monitoring the domestic equity portion of your portfolio.
Schwab Sector Views can also be useful in identifying stocks by sector for potential purchase or sale. Clients can use the Portfolio Checkup tool to help ascertain and manage sector allocations. When it's time to make adjustments, Schwab clients can use the Stock Screener or Mutual Fund Screener to help identify buy or sell candidates in particular sectors. Schwab Equity Ratings also can provide a fact-based and powerful approach for helping you select and monitor stocks.
What You Can Do Next
Review your sector allocation. If you aren’t sure how to analyze your sector weightings, a Schwab Financial Consultant can help.
Explore our views on individual sectors in Sector Views.