As investors likely realized last year, putting your money to work on Wall Street can be an adventure, at least in the short run. In 2022, the ageless Dow Jones Industrial Average (^DJI 0.56%), benchmark S&P 500 (^GSPC 0.11%), and growth-dependent Nasdaq Composite (^IXIC +0.35%) were all (at least briefly) entrenched in a bear market, with the Nasdaq taking the brunt of the pain (down 33%).
But 2023 has been a different story thus far. Whereas the Dow is relatively unchanged for the year, as of this past weekend, the Nasdaq Composite has rocketed higher by 17%. This outperformance is being led by brand-name, megacap companies, predominantly found in the tech sector.
Image source: Getty Images.
Tech stock outperformance is off the charts
It's no secret that tech stocks have been outperformers since the end of the Great Recession. Dovish monetary policy from the Federal Reserve offered more than a decade of historically low borrowing costs that allowed tech companies to hire, acquire, and innovate.
Access to cheap capital has fueled outsized growth rates. Even though value stocks have the edge over growth stocks over the very long term, based on a Bank of America/Merrill Lynch study from 1926 through 2015, it's growth stocks that have handily outperformed since 2009. Investors have had a willing appetite for risk in a low-interest rate environment.
Tech stocks also have a habit of outperforming other sectors during recessionary periods. With a number of indicators and metrics, along with the Federal Reserve, suggesting that a U.S. recession is likely at some point in the not-too-distant future, the expectation would be for tech earnings to decline at a slower pace than other sectors.
This is the greatest outperformance of US Tech versus the S&P 500 we have ever seen. $SPY $QQQ $AAPL $MSFT $NVDA pic.twitter.com/wWSANYLwad
-- David Marlin (@Marlin_Capital) May 5, 2023
But we're also witnessing history from tech stocks. Based on data from BofA Global Investment Strategy, which Marlin Capital CEO David Marlin reposted on social media platform Twitter, U.S. tech stocks are enjoying their greatest outperformance, relative to the S&P 500, in 97 years.
There have only been two times since 1926 where tech stocks even came close to outperforming the S&P 500 to the magnitude we're seeing now: January 1970 and February 2000. Following January 1970, the S&P 500 went virtually nowhere for nine years. Meanwhile, it took the benchmark S&P 500 nearly 14 years to break out to new highs following February 2000. Historic precedence would suggest that tech stock outperformance of this magnitude isn't good news for Wall Street.
Megacap tech stocks may struggle to sustain their lofty valuations
Then again, you probably didn't need BofA Global Investment Strategy to tell you tech stocks are pricey. Quite a few megacap tech outperformers could struggle to justify their current valuations.
For example, few megacap tech stocks have raised eyebrows quite like Nvidia (NVDA +2.59%) has in 2023. Nvidia, which is best known for developing and manufacturing graphics processing units (GPUs) used by hardcore gamers, has had its shares surge 94% this year.
NASDAQ: NVDA
Key Data Points
More importantly, Nvidia's price-to-earnings (P/E) ratio, based on Wall Street's consensus for fiscal 2024 (Nvidia's fiscal year ends in late January), has ballooned to 68 on the heels of the company's artificial intelligence (AI) ties. The massive addressable market for AI has investors not wanting to miss out on this next-big-thing opportunity.
But there's another side to this story. Every next-big-thing investment for the past 30 years has been overhyped by Wall Street, with adoption of said innovation, product, or service taking longer than expected. Although AI has the potential to be a long-term game changer for Nvidia, history suggests the current AI hype will eventually fade.
What's even more worrisome is that Nvidia's high-margin gaming segment has seen sales fall off a cliff in its previous three reported quarters. Gaming revenue declines of as much as 51% completely stalled Nvidia's growth engine in fiscal 2023.
It's a similar story for Wall Street darling Apple (AAPL 0.01%). Shares of Apple have surged 33% since the year began, yet Wall Street's outlook for the company in fiscal 2023 (Apple's fiscal year ends in late September) continues to worsen.
NASDAQ: AAPL
Key Data Points
Although Apple doesn't sport an egregiously high P/E ratio like Nvidia, investors are still paying 32 times consensus earnings for fiscal 2023, with sales expected to slide by 11%. Keep in mind that this 11% decline in sales comes with higher-than-normal inflation as a tailwind.
Whereas Apple consistently grew by a double-digit percentage and commanded a P/E ratio of between 10 and 15 from 2013 through 2018, it's now sporting an estimated P/E ratio of 32, with sales and profits retracing by a low-double-digit percentage. That doesn't seem sustainable, especially if the U.S. economy does dip into a recession.
Sector rotation may be on deck
Taking into account that Bank of America's research on tech valuations spans 97 years, change isn't going to happen overnight. However, the historic outperformance of tech does suggest some form of sector- or investment-based rotation may be on deck.
Image source: Getty Images.
One of the most logical sectors we could see money flow into from the tech space is healthcare. Healthcare is a highly defensive sector, which makes it perfect to weather any storms that an economic downturn may bring. Since we don't have much say over when we become ill or what ailment(s) we develop, demand for prescription drugs, devices, and various healthcare services tends to be pretty consistent in any environment.
Further, healthcare stocks are incredibly innovative in their own right, with brand-name drugs and devices improving the quality of life for people worldwide.
Another sector that could see increased money flow if tech stocks begin to sour is financials. Although financials are under notable pressure at the moment due to the regional bank crisis, financials tend to be one of the top-performing sectors during the early stages of a bull market. While it's unlikely we've entered a new bull market, financials should be able to eventually take advantage of dovish monetary policy.
Another investment type to consider is small-cap stocks. Small-cap companies tend to be more volatile than their megacap counterparts. When new bull markets emerge, small caps have, historically, outperformed megacap stocks.
