What’s Driving the Current Tech Rally? Artificial Intelligence and the Fed

Stocks posted a strong rally in the first half of 2023, but many market-watchers are quick to point out that there’s really one category responsible for a lion’s share of the gains: mega-cap tech stocks.

The chart below demonstrates tech’s leadership. The tech-heavy Nasdaq (blue line) is clearly seen diverging to the upside relative to the S&P 500 in 2023. Many of these gains have been driven by the very biggest names in the industry, like Tesla, Nvidia, Meta, and others.

The powerful rally in tech shares has many investors wondering if this run is the prologue for an eventual bust, much like we saw in 1999. There are certainly similarities – in each rally, investors were seen betting on companies they believed would be the leaders in transforming the economy with new technology. Back then it was the internet. Today it’s AI.

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There is reason to be cautious. We know from 1999 that picking long-term winners proved to be elusive, with many hyped companies failing to survive the bust. The lesson from that time should be applied by investors today when surveying the landscape of AI. It would not be crazy to think that many of the companies appearing to be at the forefront of the AI revolution may not be around 10 years from now.

This is not to short-change the potential impact AI can have on economic growth and the labor market. We have written before that automation of routine tasks, optimization of business processes, personalization of the customer experience, predictive analytics, and development of new products and services look poised to change the very nature of business and work. But that’s a different statement than claiming to know which companies will ultimately lead the way.

In short, technological innovation seems likely to result in a substantial wave of new growth and profit generation, but knowing which companies will enjoy these durable earnings is a major question.

Which brings up the second driver of tech’s rally so far in 2023: the Fed. To understand how the U.S. central bank has any connection to technology stocks, it’s important to look back to late 2021 and early 2022, when the Fed made the pivot to tighter monetary policy and first started raising rates. Interestingly enough, the Nasdaq’s peak in that bull market came in mid-November 2021, which coincided very closely with the Federal Reserve’s shift in policy.

Questions started to swirl about the impact rising interest rates would have on stocks, for good reason – investors understood that rising rates would result in multiple compression over time, and in the near-term would deal a major blow to high valuation stocks, especially high-flying ‘growthy’ tech names. That’s precisely what happened, with technology shares bearing a brunt of the market downturn in 2022.

Fast-forward to today, however, and investors appear to be forecasting that the Fed is just about done raising rates. Part of this rationale is the Fed itself, which paused interest rate increases at its last meeting – though also signaling more rates could be ahead. Another rationale is falling inflation and inflation expectations, which investors think will be enough to warrant more caution from the central bank. As seen in the chart below, the 1-year, 2-year, and 5-year inflation expectations have all fallen back to pre-pandemic levels.

If the market does not see inflation being a long-term problem, it follows that the Fed should not pose a further headwind to tech shares, either. This line of thinking warrants the same kind of caution investors should apply to the promise of AI, in our view. AI’s revolutionary impact, much like a Fed decision to hold rates close to where they are today, are not foregone conclusions.

Bottom Line for Investors

Technology is clearly a driving force of innovation and economic growth, but that does not mean it’s a smart investment strategy to jump into companies that appear to be at the forefront of the AI ‘revolution.’ A better approach, in our view, is broad exposure to the sector via ETFs, which will allow investors to gain exposure to the leaders in the field as it evolves over time. Instead of trying to pick winners in a crowded and ever-changing sector, we think for many it can make better sense to simply own the sector.

Most investors can get where they need to go over the long term by owning a diversified portfolio of stocks and/or ETFs. In fact, “diversify your portfolio” is one the most basic pieces of investing advice. Sadly, in our experience many investors still put all (or most) of their eggs in one basket.

At Zacks Advantage, we strive to help every investor properly allocate their assets. In fact, we’ve put together a helpful guide to help you understand the basics of portfolio diversification, including:

• 4 myths of a properly diversified portfolio
• Why the average investor’s returns trail almost every other investment category
• How to create a truly well-diversified portfolio

Get our free guide, Is Your Investment Portfolio Actually Well-Diversified?,⁴ to learn how to create a truly diversified portfolio.

Download our FREE Guide

*This rating was awarded by The Robo Report on 4/1/2023 in respect of the period 1/1/2023 to 4/1/2023. We do not compensate The Robo Report to obtain this rating. However, we pay compensation to the Robo Report to use their logo in connection with advertising this rating.

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¹ Fred Economic Data. July 3, 2023.

² Zacks Investment Management may amend or rescind the Is Your Investment Portfolio Actually Well-Diversified? guide offer for any reason and at Zacks Investment Management’s discretion.

³ Fred Economic Data. June 30, 2023.

⁴ Zacks Investment Management may amend or rescind the Is Your Investment Portfolio Actually Well-Diversified? guide offer for any reason and at Zacks Investment Management’s discretion.

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