A year ago, the tech sector was still in the grips of a harsh bear market, sparked by a rapid advance in interest rates and it wasn’t until October that this bastion of growth found a bottom in terms of stock valuations. Even then, it wasn’t clear the worst was over until we revisited the October lows at the end of the year and only after seeing the floor hold, did the sector embark on a sustained recovery. In the first half of this year, tech became the driver behind a lift in the major U.S. indices. Our opinion was that valuations had become stretched by the start of the summer and we exited in favour of segments of the market where there was better value, such as energy.

 

 

While many investors view the NASDAQ 100 (NDX) as the proxy for technology stocks, given the high weighting of these companies in the index, the better way to view performance of this group is by looking at the S&P500 Information Technology index.  The reason is that there are companies in NDX that are not technology related.  Case in point, NDX rallied strongly in the first half, but did not get back to its recent record high reached at the end of 2021. The S&P technology index broke its 2021 record high in July and peaked out just above 3200. It too fell off its perch into August, then recovered prior to the Labour Day weekend, but failed to return to 3200 before this week’s slip.

 

There are a number of reasons for the weaker performance in tech in recent weeks. First, you have investors taking a step back to consider whether the Artificial Intelligence (AI) euphoria was overdone and are simply re-allocating capital. Aside from AI giddiness, investors crowded even more into tech because of a belief that there would be an immaculate disinflation without an actual recession. This would allow rates to gradually decline, but without companies facing the harsh reality of a contraction in demand.

 

 

 

As I wrote several weeks ago, there was a major inconsistency with this view. Without a recession, you would not get the rise in unemployment necessary to pull inflation back to the 2% target in a short enough period of time that would allow the Federal Reserve to begin lowering rates. As economists started jumping off the recession bandwagon last month, there was a realization that economic growth could re-accelerate, thus creating concern that inflation could remain elevated. This went against the view that rates would start to decline and, in fact, raised the risk that U.S. interest rates could remain higher for longer.  Remember that higher growth/risk assets will be valued lower in an environment where rates are higher. The 10yr U.S. treasury yield is trading at 4.25% today and broke above 4.30% in August – higher than the peak we saw last October. No surprise then that tech valuations began to erode. The question now is whether we should stay on the tech sideline or use this week’s fade as an opportunity to jump back in?

 

Growth prospects over the medium-term do favour having exposure to this sector, but we don’t see any urgency in doing so today. For one, we are still in a month where market volatility has been elevated in past years. Second, there are a number of key economic indicators that will shape the discussion on Federal Reserve policy and the direction of rates. The next FOMC meeting is September 20^th, where we will also get revised economic projections. Third, geopolitical issues have also crept back on to the scene, particularly with respect to China. This week’s announcement from Beijing that it was broadening its curbs on iPhone use by government workers has heightened the ongoing trade tensions between the U.S. and China. Add to that Washington’s probe into an advanced chip revealed by Huawei Technologies Co., which came out of the company’s launch of a new phone and you don’t get a smooth backdrop for U.S. companies doing significant business in that country.

 

 

Technicals will also play a role in determining a re-entry. At the time of writing, the S&P tech group was staging a modest rebound from Thursday’s slump, but the key level to watch will be the intraday low set on August 18^th (2880.7). This also coincided with a bounce off the 100-day moving average and that average is currently around 2930. If the index can hold above 2880, then we could be back to the scenario that unfolded at the end of last year.  That doesn’t mean that tech enters another strong bull phase, but it would provide a little more confidence in stepping back in. In the event that the August low doesn’t hold, then I would wait to see if 2800 becomes the next floor. Specifically, 2752 is a 38.2% retracement of the bounce from last October’s low to the peak in July.

 

There will be a time to build tech exposure back in the portfolio and that time could be here in the coming weeks. Ally and I just think there is some value to waiting a little longer.

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew Pyle

 

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