Halloween references aside, after a decade of dominance, is the sun setting on mega-cap tech stocks? (ddp)

Halloween references aside, after a decade of dominance, is the sun setting on mega-cap tech stocks? We won’t go that far, but the results from a wave of technology stocks last week was far from encouraging.

Disappointments galore

Lower business spending on advertising and cloud computing as the economy slows weighed on earnings for some of the heavyweights. Inflation and the stronger dollar, along with micro issues around execution and cost control, also sent tech stocks lower.

Weak demand for PCs finally caught up with Microsoft, while the company’s cloud business took a hit from a more measured approach to cloud spending. Alphabet’s Google ad business undershot expectations. Management called out the tough comparisons from last year’s surge in ad spending and a strong US dollar.

Apple beat expectations, and its limited guidance was good enough versus tepid expectations to send the stock sharply higher. However, it, too, guided for slower growth in the quarter ending December.

Meta Platforms' increased spending to support the metaverse and efforts in artificial intelligence caught investors by surprise. Virtual reality apparently needs significant amounts of real investment, driving a wholesale reduction in Meta’s expected profits.

Except for Apple, these former tech darlings all declined sharply following earnings, with Meta Platforms down nearly 25%.

Risks to estimates

Looking ahead, we see further risks to IT sector EPS estimates. Investment in technology seems to be already slowing, and we think a deterioration in corporate profits and confidence will set up a more difficult 2023. While some areas of the tech sector like software can be more defensive, we estimate roughly 35% of the sector’s earnings are driven by the consumer, whether through purchases of smartphones and other consumer electronics, or through the processing of credit card payments.

Higher interest rates have been a headwind for growth stocks over the past year as future cash flows are worth less in an inflationary environment. Valuation for the tech sector has corrected sharply, with the current P/E of 20.7x down 28% from the December 2021 high.

So do current valuations price in a reasonable downside scenario? Yes, to some extent; however, there is an exceptionally high level of uncertainty given the potential for a synchronized global downturn, the unknown amount of demand pull-in across the sector from the 2020–21 period, and the potential for a more significant derating given the inflation rate and interest rate volatility.

Cheaper but not cheap

As we have said before, the IT sector is cheaper, but not “cheap” as tech stocks’ valuation is still a rich 24% premium to the market. We see further risk to the tech sector’s premium valuation due to higher inflation and interest rates.

In our view, this premium would be deserved if the group were posting above-market earnings growth. However, after years in the limelight, the IT sector is less special. The sector’s EPS growth rate relative to the S&P 500 topped out in 2Q20. Margins and returns are still admirable, but more economically sensitive sectors like energy, financials, and industrials have benefited from higher macro factors and narrowed the gap with the technology sector. Not surprisingly, these sectors have also outperformed the broader S&P 500 and tech stocks.

We continue to have a least preferred view on US equities, and on the information technology and consumer discretionary sectors. These two sectors account for 37% of the index and skew more toward growth, where we also have a least preferred view.

Against this backdrop, we continue to prefer US large-cap value stocks, which should see continued support from higher interest rates. We also prefer energy, healthcare, and consumer staples because of their attractive valuations.

Main contributors: Solita Marcelli, Kevin Dennean

Content is a product of the Chief Investment Office (CIO).

Original report - Tech stocks get booed, 31 October, 2022.