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Schwab Sector Views

Schwab Sector Views: Why the Tech Sector Isn’t Big Enough

Key Points
  • The information technology sector now makes up more than a quarter of the overall market—but given its place in our economy, it may not be big enough.

  • However, changes are coming that will alleviate concerns about one sector becoming too large.

  • Despite the already solid gains for tech stocks, we believe there is potentially still more outperformance to come.

Schwab Sector Views is our three- to six-month outlook for 11 stock sectors, which represent broad sectors of the economy. It is designed for investors looking for tactical ideas. We typically update our views every two weeks.

Tech is big…but could be much bigger

The technology sector now makes up more than a quarter of the total market cap of the S&P 500® index. This is its largest percentage since the peak of the tech bubble in 1999, when it topped out at over 30% of the index, and larger than any other sector in at least the last 25 year (Bespoke Investment Group). This has caused some concern among investors. I have received questions regarding the possibility of another “bubble,” and have read various stories asking whether the tech sector is now too big for its own good. My answer to both—for now—is no.

First, back in 1999 the share of earnings for tech compared to the rest of the S&P 500 was roughly 13%, while its market cap share was around 30%—a difference of 17%. Now, however, the sector’s earnings make up roughly 24% of the S&P 500 (subject to small changes during the upcoming earnings season, and price movements), a difference of only about 2%. That means the sector’s market cap is roughly equal to its earnings share—not what you would probably expect to see if we were in a bubble (data provided by Strategas Securities).

But let’s go further: Is a quarter of the market representative of what tech actually contributes to our economy?  I would argue no. Think about your car. Now, my family drives a ’99, a ’95 and an ’05, but I would assume most of readers of this publication have newer cars. From what I’ve seen, they are more computer than car in some ways—able to determine when the driver should stop, when the car may be drifting into another lane, how hot and cold it is, what the tire pressure is, able to provide directions, and on and on. It wouldn’t be much of a stretch, in my view, to classify car companies as tech companies. And what about some energy companies? According to a Financial Times story (March 4, 2018), Schlumberger said that in 2014, 13% of jobs at U.S. onshore wells were supported by technical experts watching from its Houston campus; by the end of 2017, it was up to 31%. Is that an energy company or a tech company? And then there are defense contractors: if you’ve ever had the privilege of seeing inside the cockpit of an F-35, or the bridge of a new aircraft carrier, it’s hard not to view these as technology-laden products. Finally, retailers are selling goods, but what systems are they using to order, deliver, process, sell, manage inventory, optimize employment, etc?

Clearly, tech is becoming almost an omnipresent factor in our lives, and S&P recognized this. Obviously, it wouldn’t make for a diversified market if more than half of the index was concentrated in one sector—so they are increasingly differentiating between companies whose primary business is supplying tech-related products versus those that are using technology to provide another product or service. To that end, in September they will be paring back the number of companies in the tech sector and moving some to the new communications sector, such as Google and Facebook, and others to the consumer discretionary sector (such as eBay). The change is still a few months away, but the result will be a much smaller tech sector, with Ned Davis Research estimating a market cap reduction to roughly 18-19%, which should help to alleviate some concerns about one sector taking up too much of the overall market.

And tech sector gains should continue

As mentioned, the tech sector, despite some minor pullbacks, has had a good run of outperformance and continues to be the best performing group of 2018, at least to this point.

Tech has been a solid outperformer

Just because it has outperformed for a while doesn’t mean it can’t continue to do so, and it appears to us that the tech run can likely continue (however, we do want to remind investors that diversification is important, and you should check your allocations periodically to make sure they haven’t gotten off kilter). We are finally starting to see measures of capital expenditures start to tick higher, which should benefit providers of tech products. There is no doubt it’s been slow in coming, with data from Strategas revealing that the 21% rise over the past 42 quarters of this economic expansion in real private non-residential fixed investment is the lowest cumulative growth rate in any economic expansion since at least 1948. But that may be accelerating. According to EvercoreISI Research, their well-respected survey of companies revealed the highest level of tech capex spending plans in the 17-year history of the survey.

Other surveys also indicate an increase in capital expenditures, with both the National Federation of Independent Business (NFIB) and the Duke/CFO Magazine Global Business Outlook showing spending plans generally growing over the recent history.

Capex plans are growing

And tech spending plans have risen despite recent dip

Your view on interest rates and inflation could also affect your view on tech—and for now, trends seem to favor further Fed rate increases. According to EvercoreISI Research, tech sector relative performance has had a 36% correlation with 10-year yields, the highest of any sector, meaning that as yields move higher, tech has a greater tendency to outperform than any other sector. Likewise, Even though past performance is not an indication of future results, Strategas Securities has data showing tech has tended to have the highest return level during periods of rising inflation over the past 20 years,

Yields have trended higher

As has inflation

And we’ve talked before about the additional tailwind that could come from companies bringing overseas cash back to the U.S. in the form of increased dividends, buybacks and potential merger and acquisition activity.

Global problems?

In investing there are always risks, and certainly that is true for tech as well. First, valuations aren’t cheap in our view, with the forward price-to-earnings ratio of 19 slightly above the longer-term average of the sector (FactSet). Perhaps more importantly, the tech sector gets about 57% of its revenue from overseas sources, the second-highest out of all eleven sectors (Strategas). That could leave the sector vulnerable in at least two ways. Recent dollar strength makes U.S. goods more expensive to foreign buyers, and could result in reduced demand.

Continued dollar strength could cause problems

Also, as trade tensions escalate, the threat of increased tariffs on U.S. tech goods grows. According to the Business Roundtable’s latest survey, 95% of CFOs are concerned about a “moderate or serious risk of trade retaliation leading to lower exports.”  For now, we don’t believe these risks are large enough to warrant a downgrade of the sector, but they are worth watching.

Finally

The tech sector is large, but given its place in the U.S. economy its size seems justified, and in our view it could be even bigger. But changes are coming that should alleviate some of those concerns, by reducing the relative size of the sector. Despite the long-running outperformance of the sector, we believe there is likely still more to come, and continue to hold our “outperform” rating on the tech sector.

Schwab Sector Views: Our current outlook

Sector

Schwab Sector View

Date of last change to Schwab Sector View

Share of the
S&P 500 Index

Year-to-date total return as of 06/19/18

Consumer discretionary

Marketperform

07/17/2014

13%

14.06%

Consumer staples

Marketperform

05/07/2015

7%

-9.37%

Energy

Marketperform

11/20/2014

5%

5.02%

Financials

Outperform

05/07/2015

15%

-1.22%

Health care

Outperform

01/26/2017

14%

3.58%

Industrials

Marketperform

01/29/2015

10%

-2.55%

Information technology

Outperform

04/29/2010

25%

14.32%

Materials

Marketperform

01/31/2013

3%

-2.35%

Real estate

Underperform

01/26/2017-

3%

-2.91%

Telecom

Underperform

09/12/2013

2%

-9.48%

Utilities

Underperform

05/23/2013

3%

-2.99%

S&P 500®  Index (Large Cap)

 

 

 

4.28%

Source: Schwab Center for Financial Research and Standard and Poor’s as of 05/31/18.

Clients can use the Portfolio Checkup tool to help ascertain and manage sector allocations.

What is Schwab Sector Views?

Schwab Sector Views is our three- to six-month outlook for 11 stock market sectors, which are based on the 11 broad sectors of the economy.

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 rest of the market.
  • Underperform: Likely to perform worse than the rest of the market.
  • Marketperform: Likely to track the broad market.

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 allocations to each sector, listed in the chart above, as a guideline.

Investors who want to make tactical shifts in their portfolio can use Schwab Sector Views’ outperform, underperform and marketperform 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. 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 an objective and powerful approach for helping you select and monitor stocks.

What You Can Do Next

To discuss how this article might affect your investment decisions:

Schwab Market Perspective: Rough Waters for Summer?
Schwab Market Perspective: Searching for Balance
Materials Sector Rating: Marketperform

Important Disclosures

Schwab Sector Views do not represent a personalized recommendation of a particular investment strategy to you. You should not buy or sell an investment without first considering whether it is appropriate for you and your portfolio. Additionally, you should review and consider any recent market news.

All expressions of opinion are subject to change without notice in reaction to shifting market or other conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.  The above mentioned companies should not be construed as a recommendation or endorsement.

Diversification and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

The S&P 500 Index is a market-capitalization-weighted index comprising 500 widely traded stocks chosen for market size, liquidity and industry group representation.

The S&P 500® Information Technology Index comprises those companies included in the S&P 500 that are classified as members of the GICS® Information Technology sector.

The National Federation of Independent Business (NFIB) Small Business Optimism Survey which is based on the responses of 740 randomly sampled small businesses in NFIB's membership, surveyed monthly.

The ICE U.S. Dollar Index is a geometrically-averaged calculation of six currencies weighted against the U.S. dollar. The contract was established in 1973 and includes six currencies: the Euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc.

The Consumer Price Index (CPI) is an index that measures the weighted average of prices of a basket of consumer goods and services, weighted according to their importance.

The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of Morgan Stanley Capital International Inc. (MSCI) and Standard & Poor's. GICS is a service mark of MSCI and S&P and has been licensed for use by Charles Schwab & Co., Inc.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

(0618-8LF5)

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