Does Tech reliably lag when yields rise? No

We often hear the narrative that rising long-term bond yields are harmful to valuations of “long duration” Growth stocks, especially the Technology sector that dominates the Growth style. This has been evident in day-to-day swings in the market recently.

While we understand the concept embedded in discounted cash flow models that higher discount rates depress current equity values more when capitalizing earnings that occur further in the future, we have been skeptical that the discount rate effect in most cases is sufficiently large to dominate changes in growth expectations or investor risk tolerances, at least for the Tech sector.  In other words, our view has been that an investor’s bigger concerns when evaluating higher-Growth Technology stocks are the future earnings growth rate and the risk involved, not whether Treasury bonds yield 1.5% versus 2%. Changes in growth expectations and investor risk perceptions will typically have much larger effects on stock prices than moderate changes in Treasury yields, especially when interest rates (and real rates in particular) are at such a historically low level.

Tech fundamentals still favor Hardware over Software

While the Technology sector has been less dominant in terms of returns this year than it was last year, it remains the largest sector in the US market by value and the focus of much investor attention.

Our view within the Technology sector for some time now has been to favor hardware-related industries over software-related or services areas, and the latest update of both bottom-up and top-down indicators continues to support this view.

Semis vs Software trade now favors Semis

Within the broad Technology sector, there are often significant divergences among the various industries. A key intra-sector industry relationship that many investors use as a touchstone is the relative performance of Semiconductors versus Software.

These two industries capture different parts of the Technology ecosystem. Due to their widespread use in so many devices and products, the Semiconductors and Semiconductor Equipment industry reflects demand for hardware, both within Technology (servers, PCs, phones) and in other sectors (e.g. autos), and thus tends to be much more cyclical. Software tends to be much more stable, with more recurring revenue, and nowadays is closer to a service-type industry. There is much less chance of major “shortages” or “oversupply” of software of the kind that semiconductor makers must often deal with.

Tech Sector In The Driver’s Seat For US Relative Performance

In this post, we highlight the interaction of US outperformance versus the rest of the world this year and US Technology relative to Ex-US Technology.

First, the relative performance of the US equity market versus the rest of the world has been highly correlated with the relative performance of US Technology stocks relative to Ex-US Technology stocks.
Second, the outperformance of US Technology, and by extension the major US indices versus their non-US counterparts, looks likely to continue based on relative earnings estimate revisions patterns.

Growth leadership easing as rotation increases

One of the most notable market trends in recent weeks has been the corrective action in the formerly high-flying US large-cap Growth stocks. The dominant Tech-oriented companies that have been responsible for much of the gains in US large-cap indices for several months finally saw some significant selling pressure in the first two weeks of September.

The first chart below shows absolute and relative returns for the S&P 500 Pure Growth and Pure Value indices (i.e., the style indices restricted to stocks that fall entirely into their indicated style, leaving out those with weight in both indices).

Global Technology: still outperforming, but is it expensive?

Much of the attention in equity markets has been focused on the Technology sector, many of whose constituents are reporting Q2 earnings now. The Technology sector has outperformed dramatically both in the US and globally in recent years as well as for the year-to-date. This has raised questions about whether the sector is “overowned” and overvalued, particularly given its unusually high weighting in the S&P 500 index now.