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Zacks Advantage Blog

3 Reasons the Tech Sector is Not Overvalued

November 20th, 2020 | Posted in Investing

Think Tech is Overbought? 3 Reasons to Reconsider!

Through the first three quarters of 2020, the Technology sector has soared +28.7% – making it the top performing category year-to-date. By comparison, the S&P 500 index is up a far lesser +5.6% for the year (through September 30).1

As many readers know, Technology’s outperformance isn’t unique to 2020 – it’s been going on for the better part of the last decade. But the sector’s meteoric rise has many investors wondering how long the outperformance can last, and whether we should brace for a repeat of the 2000 crash. Valuations are indeed pushing eerily higher, and one can only wonder if the technology sector is overbought. We have three reasons to believe it isn’t.

1. Technology Stocks Have Earnings Strength

2020 full year earnings-per-share estimates suggest the S&P 500 Technology sector could post earnings growth of 19%.2 This is earnings growth in a year when the pandemic wreaked havoc on the economy and led to millions of job losses.

Technology’s resilience, of course, is based on robust performance in the ‘digital economy’ – i.e., the shift to working remote, e-commerce, enterprise cloud, and companies’ reliance on software and digital tools to function and grow in the modern economy. Many technology companies who are building and servicing this digital economy sport impressive margins and significant free cash flow. Amazon earns approximately $600,000 in revenue per minute.

Compare the companies of 2020 to the dot-com companies that drove the late 1990s tech surge, and you will find very few similarities.

2. We May Be in the Early Stages of a Technology ‘Super-cycle’

The Industrial Revolution arguably lasted somewhere in the neighborhood of 100 years, transforming the global economy in many ways and generating long-term, secular growth – the fruits of which we can see today. Thinking far ahead into the future, there may be a good argument that technology is driving another economic ‘super-cycle,’ of which we may be in the early stages.

Twilio, a leading cloud communications platform, recently published research finding that “97% of enterprises have accelerated their digital transformation efforts in response to Covid-19, and their digital communications strategies have sped up by an average of six years. 92% of companies are also looking to expand their digital communication channel.”3 In short, companies are aware that the future is digital, and they are scrambling to align their businesses with this new reality. The shift to technology is accelerating in the wake of the pandemic, not slowing down.

In the coming years and decades, non-technology companies may be differentiated not so much by the types of services and products they provide, but how superior their technology is in making and delivering their products and services to consumers and businesses.

3. Lower-for-Longer Interest Rates May Support Higher Valuations

Near-zero interest rates have implications for nearly all asset classes, not just bonds. If an investor can expect to earn only 1% on a 10-year U.S. Treasury, the desire for a better return is likely to push them further out on the risk curve. Many land in stocks.

In particular, investors who expect “lower-for-longer” interest rates may look to invest long-dated assets, where cash flows tend to be further out into the future. Tech stocks match this profile. Looking at this another way – if risk-free U.S. Treasury bonds only offer a 1% yield, an investor may reasonably demand a return of 4% from stocks, factoring-in a 3% “equity risk premium.” An earnings yield of 4% on stocks implies a P/E ratio of 25, signaling investors may be comfortable with higher-than-normal valuations.

An equally-weighted index of Technology stocks shows them trading at 26.89x forward earnings, which is almost half the P/E levels we saw during the late 1990s tech bubble. The expectation of lower-for-longer interest rates is pushing capital to risk assets, arguably justifying higher valuations.

Bottom Line for Investors

It may feel unsustainable for a handful of tech companies to account for such a large percentage of the total equity market’s capitalization and gains. But technology is also the driving force behind corporate earnings gains and economic growth in an otherwise challenging year. If investors go where the money is being made, it leads to the Technology sector, in our view.

That being said, we do not believe it wise for investors to go ‘all-in’ on Technology. An equity market correction may ultimately lead to a rotation of capital from high valuation names to low valuation names, and we could see a rotation from growth to value. Going forward, we do not believe technology and growth stocks can outperform indefinitely, and we think it makes sense for investors to stay diversified. Technology may lead for years and decades to come, but the sector will not always outperform, in our view.

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1 Strategas, Quarterly Review in Charts, October 2, 2020.

2 Black Rock. September 17, 2020.

3 Black Rock. September 17, 2020.

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss

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