When U.S. information technology stocks faltered in June after rallying earlier in the year, a number of commentators warned that the sector had experienced a bubble that was in danger of bursting. In our view, a temporary retrenchment is always possible, especially given the sector’s recent valuations, which have been toward the high end of their historical range. However, we remain bullish on the sector in the intermediate term, as we believe the current market environment is very different from the dot-com bubble in the late 1990s.
Our constructive view on technology stocks stems in part from an investment theme that we believe will continue to play out this year and in coming years: The primary driver of market returns is shifting from multiple expansion—stocks rising ahead of the pace at which earnings are growing, as reflected in price-to-earnings (P/E) ratios—to expectations of rising earnings and dividend increases. This shift has been triggered in part by central banks’ gradual pullback of quantitative easing, or purchases of government debt or other fixed-income securities. These monetary policies were designed to bring about lower interest rates, increase the money supply, and stimulate economic growth in the wake of the 2008 global financial crisis. They also became a key factor that drove equity prices higher; about two-thirds of the nearly 100% increase in the S&P 500 Index from 2012 to 2016 can be attributed to multiple expansion.1 With quantitative easing and multiple expansion waning, earnings growth has become critical. We believe recent earnings trends will remain positive, especially for the tech sector, and expect that they’ll be strong enough to support higher stock prices in the quarters ahead.
“This time is different”
Although we believe that those four words are the most dangerous words in investing, the maxim aptly summarizes our perspective. While the U.S. tech sector has recently enjoyed a great run, its returns over the past few years have paled in comparison with tech’s huge gains in the late 1990s, leading up to the sector’s previous record high in March 2000.1 That bubble had plenty to do with hype and precious little to do with tech stocks’ trailing earnings or 12-month earnings expectations; in contrast, over the past couple of years, tech stocks have enjoyed solid earnings growth, and equity price appreciation in the sector only recently began to pull ahead of earnings gains.
As for valuation, the tech sector was recently trading at a premium of about 11%, as measured by its forward P/E ratio relative to the overall U.S. equity market. While this premium is higher than the tech sector’s 10-year average of 6%, it’s well below the 34% mean average over the past 22 years, dating to the sector’s rally in the late 1990s.2 Tech’s recent premium strikes us as eminently reasonable, given the sector’s superior earnings outlook relative to the broader market. If there is a relative mispricing here, we think the premium may actually be a bit too low. We believe other measures also support our contention that tech valuations, while moderately stretched, largely reflect broad equity market trends and that earnings are likely to be the key driver going forward.
The technology stock rally has an open road ahead
Tech has an enviable track record when it comes to posting robust earnings numbers, with the sector’s earnings-per-share (EPS) growth averaging 10.9% over the last decade.3 While this growth has slowed a bit during the last couple of years, tech earnings have outperformed almost all other sectors and have continued to consistently beat analysts’ consensus estimates. For example, since the first quarter of 2014, 82% of tech companies have beaten EPS estimates; over the past four quarters, the rate has improved, with 89% surprising to the upside.4 Furthermore, tech sector earnings were expected to grow by an impressive 15.1% in the second quarter of 2017, versus a 4.8% growth rate for the S&P 500 Index, excluding stocks in energy, a sector that experienced rapid earnings growth from a low base in 2016 amid a slump in energy prices.4 While it may prove to be unsustainable for tech stocks to maintain such strong earnings growth, we believe the outlook is solid, reflecting a number of momentous developments and innovations emanating from the sector.
Dance of the robots
Why does the tech sector possess such an enviable track record when it comes to growing earnings? In their most recent book, MIT Professors Andrew McAfee and Erik Brynjolfsson emphasize five interdependent and overlapping developments that they refer to using the acronym DANCE:
- Data—90% of the world’s digital data was created within the last 24 months
- Algorithms—Whose results improve as the amount of data they’re fed increases
- Networks—Where speed improvements mean better and faster data and analysis
- The Cloud—Makes available an unprecedented amount of computing power and allows every member of a robot, car, or drone tribe to quickly learn what every other member knows
- Exponential improvements in digital hardware—This is Moore’s law, which continues to drive dramatic improvements in core processors, sensors, and so on5
The tech sector increasingly reflects these key themes. Further, the nature of winner-takes-all markets implies greater concentration in a majority of sectors and the increased importance of identifying global champions. In our view, such companies have a stronger potential to exhibit higher profit margins and returns on equity, reflecting their digital moats, lower labor costs, and the evolution to a more capital-light balance sheet. In addition, such companies are more likely to have plenty of financial resources to increase dividends or buy back shares—an important factor to Epoch Investment Partners, as we believe it provides a promising backdrop for shareholder yield strategies.
For these reasons, we remain constructive on the tech sector’s outlook for the intermediate term, despite valuations that appear somewhat overextended, opening up the possibility of a short-term setback. We expect tech to continue to exhibit solid earnings growth, and believe this strength will prove sufficient to support higher stock prices for the sector in the quarters ahead.
1 Bloomberg, Epoch Investment Partners, 2017.
2 Bloomberg, Epoch Investment Partners, as of 7/31/17. The U.S. market is represented by the MSCI USA Index, which measures the performance of publicly traded large- and mid-cap stocks of U.S. companies.
3 Wolfe Research, as of 3/31/17.
4 FactSet, as of 8/31/17.
5 Machine, Platform, Crowd: Harnessing Our Digital Future, Andrew McAfee and Erik Brynjolfsson, 2017.