Prophets

For Stocks to Succeed, Tech Needs to Lead Again

The sector is actually cheaper than some others, even though revenues are forecast to grow faster than any other S&P 500 group.

Stock bulls need to root for tech.

Photographer: Spencer Platt/Getty Images

The consensus holds that U.S. stocks are set for another positive year in 2018, but the most important question for investors is this: Which sector will outperform the most? Theories abound. Financials should benefit from further deregulation. Infrastructure spending should help the shares of industrials and materials. All reasonable thoughts -- but for stocks to have another good year, technology must again take a leadership role. 

To understand why, let's start with the rationale behind the consensus. All major global economies are growing, and interest rates are still low. U.S. stock markets faithfully followed the fundamentals in 2017 and tuned out political noise, nuclear threats and a host of other distractions. There is little reason to think 2018 will be any different.

Interest rates top the list of areas where the consensus could be wrong. With central banks reducing their bond purchases (or, in the case of the Federal Reserve, actually shrinking their portfolio), longer-term rates could rise faster than expected. An analogous risk: Inflation could surprise by accelerating. Separately, U.S. politics could bubble over and hurt consumer confidence. That hasn't happened so far, but that could change. 

The implications for tech stocks are twofold. First, in the case of the S&P 500, the group represents 24 percent of the index. That's essentially the same weighting as telecommunications, real estate, materials, utilities, energy and consumer staples combined. If U.S. stocks rise as expected, index math and historical price relationships strongly suggest tech stocks will perform better than the market overall because their betas tend to be greater than 1.0. And if they are a drag on the S&P 500, the index will need some pretty lofty performance from other sectors to offset that headwind.

Second, still-low interest rates should continue to support tech valuations. Most of the future earnings power embedded in tech valuations are many years distant, and lower long-term interest rates boost discounted cash flows valuations. So if you are looking for 10-year Treasury yields to go to 4 percent because inflation accelerates, tech probably isn't for you.

The only factor that permanently shifts asset prices is surprise, and it's difficult for many sectors to show truly unanticipated financial results this late in an economic cycle. Coming off an economic trough, industrials easily beat expectations, as do financials and consumer cyclicals. But late in a cycle, analysts and investors have tuned their models to more accurately predict marginal revenue/earnings calculations. It then becomes much harder for these sectors to beat expectations or for their stocks to meaningfully outperform.

By contrast, large-capitalization tech companies have two ways to surprise in 2018. The first is to continue to show earnings leverage within their existing businesses. The second is to continue to destroy business models in other industries. Amazon.com's stock price performance over the last decade is a neat study in the latter point. The old tech mantra of "Move fast and break things" will still apply in 2018.

So, even with this advantage, how could tech underperform? The one-word answer is "regulation." The relationship between Washington and the tech world is currently strained, and we are entering a political year with the U.S. midterm elections. Moreover, European regulators are growing more critical of U.S. tech companies and their impact on local economies.

Finally, fundamentals and valuation both point to large-cap tech outperformance this year. A few highlights (data courtesy of FactSet's latest Earnings Insight Report):

  • If you are looking to play a global synchronized economic recovery, then tech is the only sector in the S&P 500 with over 50 percent of revenue coming from outside the U.S.
  • Wall Street analysts expect large-cap tech companies to have the highest revenue growth in 2018 of any of the 11 sectors of the S&P 500, at 10.2 percent, and those estimates were rising throughout the fourth quarter of 2017.
  • That revenue growth should lead to 12.7 percent earnings growth. Some cyclical sectors, such as materials and financials, do show better-than-expected growth but may not receive much of a valuation bump since markets will assume their growth is transient rather than secular.
  • Large-cap tech companies had the highest operating margins of any sector (ex-real estate, where the numbers are not comparable) in the S&P 500 in the third quarter, or 20.2 percent. Financials were a distant second at 13.7 percent.
  • Yes, large-cap tech stock valuations are high (18.9 times this year's earnings), but consumer discretionary (21 times), consumer staples (19.9 times) and industrials (19.4 times) are all higher.

Where this could all go wrong is in the yet-unknown effects of the recently passed U.S. tax reform bill. Markets have given stocks a pass on the particulars of this legislation, but now the heavy lifting of parsing the details begins. Will large cap tech companies start repatriating offshore cash and buy back stock immediately, or will they prefer to invest in acquisitions? Will consumers spend their tax savings, and if so, where? Right now, no one can be sure. 

    To contact the author of this story:
    Nicholas Colas at nick@datatrekresearch.com

    To contact the editor responsible for this story:
    Robert Burgess at bburgess@bloomberg.net

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