Over the long run, Wall Street has shown time and again that it's a wealth-building machine. Even though stock market corrections are commonplace, the broad-market indexes tend to rise over long stretches.

Among the 11 sectors of the market, none has captivated investors' attention more than tech stocks. Since the end of the Great Recession (2007-2009), the tech sector has enjoyed nearly uninterrupted access to historically cheap capital. More than a decade of favorable monetary policy from the Federal Reserve allowed tech stocks to cheaply borrow in order to hire, acquire, and support innovation.

A person holding a smartphone that's displaying a volatile stock chart with buy and sell buttons above it.

Image source: Getty Images.

Tech stocks were also Wall Street's darlings during the recently ended first quarter. With virtually all mega-cap tech stocks rising by a double-digit percentage to start the year, the benchmark S&P 500 (^GSPC -0.71%) and technology-driven Nasdaq Composite benefited notably. 

Unfortunately for tech investors, one new data point is sounding a warning on Wall Street.

Tech stock valuations are getting pricey

Less than two weeks ago, Cameron Dawson, the chief investment officer at NewEdge Wealth, offered some thoughts on the tech sector via Twitter. Dawson's thread labeled tech stocks as being largely responsible for the gains the major indexes have enjoyed in 2023.

However, Dawson also pointed to something tech investors may be ignoring or not giving enough attention: premium valuations in the sector.

Historically, it's not uncommon for price-to-earnings (P/E) multiples in the tech sector to be higher than the average P/E ratio of the S&P 500. Tech stocks not only tend to grow faster than most sectors of the market, but they've historically held up better during recessionary periods, as noted by Dawson. The smaller profit declines tech stocks experienced during the Great Recession and the initial stages of the COVID-19 pandemic helped the sector sustain a higher P/E ratio.

But as of the end of March 2023, the aggregate P/E ratio of technology stocks was 38% higher than the S&P 500's P/E ratio. This is an even higher premium than tech stocks exhibited in 2021, which is when the proverbial cheap capital spigots were on full blast. At the moment, the technology P/E premium, relative to the S&P 500, is double its five-year average.

Multiple indicators provide a warning for investors

Normally, a high valuation by itself isn't enough of a reason for investors to worry. But that's not always the case.

As an example, the S&P Shiller P/E ratio has a knack for forecasting eventual downside in stocks. I say "eventual," because it doesn't predict how long stocks, collectively, can remain pricey.

When back-tested to 1870, there have been six instances where the S&P Shiller P/E ratio has crossed above and sustained 30, including February 2023. In the other five previous instances, the S&P 500 eventually lost at least 20% of its value. Again, stocks can remain pricey, on relative basis, for an extended period of time. Eventually, though, a bear-market-sized decline has always been the result.

Premium valuations also become less tolerable during bear markets (as we're in now), and when recessions arise. Though the U.S. isn't in a recession, a trio of recession-probability indicators have provided a warning to investors.

10 Year-3 Month Treasury Yield Spread Chart

Historically, yield curve inversion have been bad news for the U.S. economy. 10 Year-3 Month Treasury Yield Spread data by YCharts. Gray areas denote recessions.

For instance, the Federal Reserve Bank of New York has a recession probability tool that determines the likelihood of a U.S. recession within the next 12 months based on the spread (i.e., difference in yield) between the three-month and 10-year U.S. Treasury bonds. After 1966, anytime the probability of a recession has hit at least 40%, the U.S. has dipped into recession. It was 57.77% in March. 

Additionally, the U.S. ISM Manufacturing New Orders Index, as well as the Conference Board Leading Economic Index, have presented data that suggests an increased likelihood of an economic downturn.

Even though tech stocks have fared better than other sectors on an earnings basis during previous recessions, it's not clear if investors will support this rich of a P/E premium to the benchmark S&P 500.

Be smart and tread lightly

Recently, I've highlighted a handful of tech stocks that aren't attractive at their current valuations. This includes the king of the hill, Apple (AAPL 0.06%), as well as the top-performing mega-cap in 2023, Nvidia (NVDA -2.61%).

Neither Apple nor Nvidia is a bad company. Apple has great leadership, a faithful customer base, and it's repurchased more than $550 billion worth of its common stock over the past 10 years. Meanwhile, Nvidia is a major player in graphics processing units and is riding the artificial intelligence (AI) wave higher.

But both companies have lofty valuations and a near-term growth problem. Even with historically high inflation as a tailwind, mediocre sales of Apple's iPhone 14 have the company set to report a modest sales and profit decline in fiscal 2023, according to Wall Street estimates. Likewise, Nvidia's highly profitable gaming unit has seen sales drop by around 50% as inventory gluts in the personal computing space take hold. Apple at an estimated 28 times fiscal 2023 earnings, along with Nvidia at a forecast 60 times fiscal 2024 earnings, aren't attractive.

But just because certain tech stocks are priced for perfection, it doesn't mean there aren't values to be had. Investors simply have to be smart about where they're putting their money to work.

A perfect example would be semiconductor stock Broadcom (AVGO -1.98%). Even with a healthy 28% gain in its share price over the trailing six months (as of April 7, 2023), Broadcom can still be purchased for just 15 times what Wall Street expects it to earn in 2023.

A person wearing gloves and a sterile full-body coverall who's closely examining a microchip.

Image source: Getty Images.

What's more, Broadcom tends to have a sizable order backlog. If the U.S. economy does, briefly, shift into reverse, Broadcom is able to lean on its hearty backlog to generate predictable operating cash flow. This backlog, coupled with the fact that Broadcom generates most of its sales from wireless chips found in next-generation smartphones -- smartphones and access to wireless service are practically basic necessities -- should provide a nice foundation for shareholders.

It's also important to think long-term. While valuation-driven and recession-based indicators can flash warnings from time to time, the stock market is still the same phenomenal wealth creator when measured over multiple decades.