Janos Varga
Over the past decade, the technology sector has seen the most extreme bull and bear market trends. It was a solid sector over the years leading up to 2020 and performed exceptionally well over the 2020-2021 time frame as retail investors poured money into their favorite companies. The “easy money” era created a valuation bubble that was particularly large amongst smaller, rapidly growing companies. However, as interest rates skyrocketed last year, cheap money became inaccessible, and the valuations of growth stocks naturally declined as higher interest rates caused future cash flows to face greater discounting.
The first half of 2023 has seen a resurgence in technology stocks. The Technology Select Sector SPDR ETF (NYSEARCA:XLK) has nearly tied the communications services ETF (XLC) for top performance this year at ~27%. Eight of the eleven sectors have declined or only risen by ~1% this year, with only three seeing notable returns (the other being consumer discretionary at 17%). There is very little breadth backing up the rally in technology stocks. Overall market breadth in the S&P 500 is near a record low today, with most of the S&P 500’s performance coming from Apple (AAPL) and Microsoft (MSFT). Further, the top-ten stocks in the index are responsible for 90% of the index’s returns. Historically, this is a negative indication and could signal growing overvaluation in these large technology giants.
The Technology Bull Case Today
We must remember that XLK is dominated by two companies, Microsoft and Apple, which comprise 48% of the ETF’s total holdings. The fund’s overall exposure is diversified between software, hardware, semiconductors, communications equipment, IT services, etc.; however, it has never had this much weighting in only two companies. Thus, in determining XLK’s health and value, those of AAPL and MSFT are very important since they drive the fund and the performance of most technology companies.
Compared to other sectors of the economy, the technology sector is highly hierarchical. Apple and Microsoft are huge companies that drive the business and growth of most others through their various products and services. If we are to imagine a pyramid of technology companies, I will place them at the top, with semiconductors and hardware in the middle and startups at the bottom. Smaller technology startups are fickle compared to Apple and Microsoft because they rely on either business activity or capital investment from larger firms. Thus, while we’re seeing a massive increase in layoffs in startups today, Apple and Microsoft’s 2023 layoffs remain very small.
Ultimately, I do not believe Apple and Microsoft are immune to the trends in smaller technology companies; however, these smaller companies are effectively their “frontline.” If enough startups and smaller companies fail or face significant issues, Apple and Microsoft will slow down as the acquisition pipeline slows and fewer new products are introduced. That said, the current situation has created ample available workers and allowed Microsoft and Apple to lay off workers to save money. Over the years, Apple and Microsoft have pursued many projects that have failed to turn a profit, so the current situation allows them to close such projects and improve profitability.
While this improvement is “beneficial” in the short-run, I believe their shift in focus from sales growth to improved profitability will inevitably lower their development over the coming decade. One decade ago, when QE, low rates, and technological improvement led to immense venture capital expansion, Apple and Microsoft saw tremendous growth by acquiring and integrating smaller companies. Today, we see the opposite as these companies close stalled projects and the overall investments into new technology firms slow.
AI is a “New Cost” for Apple and Microsoft
Further, while there are still technological improvements today, it is heavily skewed toward software improvements instead of hardware. Ten to fifteen years ago, there were immense improvements in storage capacity, processing speed, and new products like the iPhone, which opened the doors to tremendous growth for all companies in the sector. Today, hardware is not improving at nearly the same speed. It likely will not until a scientific advancement overcomes the growing physical obstacles in computer development (quantum, optical, etc.)
Today’s most evident and essential development is on the software side, “artificial intelligence,” which has seen immense public growth in 2023 alone. Without a doubt, the growth of AI will change many aspects of the modern internet and will likely change many people’s jobs over the next decade. Indeed, the proliferation of AI is seen as a critical bullish catalyst for technology stocks today, and Microsoft and Apple are making strides in the new market opportunity.
While AI is a vast new market opportunity, I speculatively do not believe the “technology giants” will be its benefactors. For one, AI technology is increasingly open-source, allowing smaller companies, startups, and individuals to make tremendous strides in the technology. Instead of pioneering the technology, Apple and Microsoft are fighting to keep up with their rapid expansion and racing to hire knowledgeable workers. Thus, there is some risk that they fail to keep up with the new technology, just as older technology giants could not keep up with the developments brought forth by Apple and Microsoft decades ago. To avoid this, they will likely need to invest heavily in a few AI-centric startups to integrate the technology. However, its open-source nature and rapid development could easily cause other companies to beat the slower giants in product development.
Undoubtedly, AI will be crucial for many companies over the coming decade. In my personal experience, most publicly available AI platforms are already vastly superior to Google Search and many other older information-gathering tools, so I can only imagine what it will become over the years. However, I believe the primary benefactors of AI will be traditional “old school” companies, such as logistics, healthcare, banks, education, and manufacturing which are currently using labor-intensive technology that is decades old and comparatively inefficient. Those companies will likely find huge savings by replacing workers with AI or, more likely, improving existing workers’ output by integrating AI into their workspace.
Apple, Microsoft, and other technology giants in XLK have the burden of fighting to keep up, just as IBM (IBM), Intel (INTC), and others struggled (and failed) to keep up with Apple and Microsoft two decades ago. Small and steady software development, such as from ~2010-2019, was more accessible for today’s technology giants to keep up with and benefit from. However, as social media and smartphones in the 2000s, such a significant new development can cause a revolution in the sector, potentially threatening today’s giants who, in their increasingly bureaucratic nature, fail to remain as nimble as smaller competitors.
What is XLK Worth Today?
My views regarding technology giants and AI are undoubtedly speculative, and, for now, it remains unclear how quickly AI will proliferate and how these firms may engage with it. In general, my base-case view is that the technology giants will spend and invest vast sums into the technology, but may fail to profit tremendously from it due to the immense competition in open-source technologies. Further, because these larger companies benefit from hardware development (which allows them to expand existing services and products), the slowdown in hardware technology improvement may lower the revenue growth of these companies. For example, fewer people are buying new iPhones and computers today because new models are less superior to existing models.
Additionally, while Apple, Microsoft, and others may soon save money due to layoffs, they face higher costs in many products due to increased commodity and overseas labor prices. The increase in global inflation rates, rising labor strife in Asia, and potential decline in the US dollar’s international position are all factors that I expect will disproportionately increase production costs for Apple and Microsoft. The gross margins of these firms have been firm but seem more likely to decline from today’s high levels (AAPL’s GM, MSFT’S GM) than continue to grow.
Overall, I believe these factors will lower the sales and EPS growth rate for most companies in XLK today, particularly the two giants that make up nearly half of the fund. XLK currently trades at a TTM “P/E” of 31X, 72% above the S&P 500’s overall 18X. Considering the most extensive stocks in XLK also dominate the S&P 500, I believe the XLK is effectively trading at twice the valuation of non-technology stocks. With this in mind, technology stocks are “priced” to have around 11% greater annualized EPS growth than other stocks over the next decade.
This rough figure is determined by mathematically determining the necessary EPS growth over the next decade for XLK’s “P/E” to equate its non-technology peer group and then discounting that valuation by the current ten-year Treasury bond yield of ~3.75%. This discounting is done to lower the present values of future earnings based on the comparative return found in a zero-risk asset. This method shows how a rise in the Treasury bond rate reduces the fair value of growth-sensitive stocks. If the “risk-free” rate was zero, the necessary differential would be closer to 7.2%, or the CAGR growth rate needed to double earnings in one decade. Other factors could be added to provide a more detailed growth valuation estimate (such as risk differences), but adding more complexity to our estimate would not change the result substantially. The bottom line is that XLK can only be fairly valued today if its constituents continue to expand EPS much faster than other stocks.
The current EPS growth outlook for XLK over the next 3-5 years is 12.25%, while that of the entire S&P 500 is 11.6%, and therefore, likely closer to 8-10% for those non-technology stocks in the S&P 500 (since the index remains skewed toward technology giants). Accordingly, a relatively small difference exists between the expected growth rate of significant technology and non-technology stocks. In my opinion, it may be the case that non-technology stocks have higher EPS growth than technology giants based on my outlook regarding AI. Furthermore, because Apple, Microsoft, and peers have become more consumer-focused over recent years, they carry similar, if not larger, cyclical risk exposure than most non-technology stocks. Indeed, the technology sector faces higher layoffs than others, indicating its cyclical exposure is above that of most companies.
The Bottom Line
Overall, I do not believe XLK should trade at such a significant valuation premium to non-technology stocks. Indeed, for XLK’s valuation to equate to that of non-technology stocks, it would need to lose around half of its current value. While that may seem extreme, XLK is up around 30% this year and 36% from its fall 2022 trough. The sector also averaged about $70-$90 (my price target) from 2018-2020, so this target is not so far from the fund’s historical pricing history. While the EPS of XLK’s constituents could improve through 2023 due to job and cost cuts, I do not believe that will last long-term as layoffs occur in the face of falling revenues and gross margins.
I am very bearish on XLK today and believe it is the best short opportunity among the large sector ETFs due to its strong outperformance this year. I believe XLK has risen mainly because investors have moved money out of financials and similar sectors but wish to remain invested in equities, preferentially buying technology since it was comparatively cheaper earlier this year. However, as market financial conditions continue to tighten, I believe the trend against equity investments will fade, pushing outperformers disproportionately lower due in part to the “index effect” (as the mass over-weighting of Apple and Microsoft reverses).
XLK is also a short solid target due to its lack of a substantial dividend, immense market liquidity, immaterial borrowing cost, and low short-squeeze risk due to the common short interest in most technology giants today. From a technical standpoint, I believe the timing is also very strong as XLK is only around 8% below its all-time high, indicating it may soon face resistance as it re-touches that level. Of course, those betting against XLK should be mindful of the risk that the sector breaks to a new all-time high in a bull market. From fundamental earnings and interest rate outlook, I believe this is unlikely; however, investor speculation and (potentially misplaced) hype in AI fuels a larger rally.