2022 was not kind to the technology sector as evidenced by the Technology Select Sector SPDR® Fund (NYSE:XLK) being down 27% year-to-date. Compared to the S&P 500 down 19% year-to-date, excluding dividends, the underperformance is material. The fund tracks the technology companies within the S&P 500 index, which account for over 26% of its total value.
Technology is by far the largest sector weighting in the S&P 500, the next being healthcare at just under 16%. Given its dominance in the US market indices, the outlook for the technology sector takes on added importance.
This is especially so as the opportunity costs in technology have been substantial through 2022 compared to most of the other sectors. The following table displays the performance of each of the eleven primary sectors within the S&P 500 index year-to-date, using the SPDR® S&P 500® ETF Trust (NYSE:SPY) as the proxy. It was compiled using data from State Street, its sector funds, and closing prices as of December 18, 2022.
Source: State Street Corporation
The technology sector and the S&P 500 are highlighted in yellow for ease of comparison. Looking at valuations, technology is tied with consumer staples for the highest valuation, near 21.5x next year’s estimates for a 4.7% earnings yield. I exclude real estate as PE is not the relevant valuation metric for this group.
The opportunity cost is evidenced by the energy sector, which is highlighted in blue. I covered the positive outlook and likelihood of continued outperformance by the energy sector in several recent reports:
- “Relative opportunities in energy for 2023“
- “Is the sun setting on energy stocks?“
- “A top sector choice for the coming cycle“
Given the small weighting in the market indices at under 5%, energy sector outperformance has gone unnoticed for market cap-weighted investment portfolios. Outside of energy, the sector outperformance includes four of the eleven being down 7% or less.
Technology Sector: The Big Two
With the technology sector dominating the indices, it is notable that the sector is heavily weighted to just two companies. Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) together account for 44% of the total sector value. As a result, the outlook for the sector is largely tied to its two largest companies when using a market capitalization-weighted approach, such as the XLK. For greater context, the top ten companies and their weightings in the sector are displayed below.
Created by Brian Kapp, stoxdox
One may be surprised to see Visa (NYSE:V) and Mastercard (NYSE:MA) in the top five list of the technology sector. Each is valued at a substantial premium to the market at 25x and 30x next year’s estimates, respectively. Nvidia (NASDAQ:NVDA) is valued at 42x. Rounding out the top five highlights the valuation maturity of the sector, especially considering the intermediate-term outlook.
Consensus Estimates
The following table displays consensus earnings estimates for Microsoft and Apple through mid-decade. The data was compiled from Seeking Alpha. I have highlighted the current fiscal year in yellow.
Source: Seeking Alpha. Created by Brian Kapp, stoxdox
In essence, growth rates are no longer exceptional while valuations are still well above the market. It is difficult to be particularly bearish on the two, as most would agree that Apple and Microsoft are premium companies. That said, the markets are undergoing a phase change which features an expanding opportunity set. The following consensus forecasts for Schlumberger from “Is the sun setting on energy stocks?” offers a glimpse into the increasingly competitive sector opportunities.
Source: Seeking Alpha. Created by Brian Kapp, stoxdox
Compared to Apple and Microsoft, Schlumberger looks like a dynamic growth company into mid-decade. Another example in the energy sector, from the September 7 report “CNX Resources: The Saudi Arabia of natural gas,” highlights the diversity of the opportunity set.
Source: Seeking Alpha. Created by Brian Kapp, stoxdox
The energy examples illuminate the diverse opportunities available to investors as we traverse the current phase change in the markets. The following quote from Oaktree’s Co-Chairman Howard Mark’s December 13 investor letter, “Sea Change,” offers his 53 years of experience and context for reviewing the relative attractiveness of today’s opportunity set.
…the environment is and may continue to be very different from what it was over the last 13 years – and most of the last 40 years… investment strategies that worked best over those periods may not be the ones that outperform in the years ahead.
The Drought
A defining feature of market cycles is sector leadership changes. The largest bull market in history ended in January 2022 and it was led by the technology sector. From a cycle perspective, it would be unusual and even unnatural for the technology sector to lead the next cycle. While qualitative in nature, there is reason to believe that the sector will face relative headwinds.
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