Tech Stocks Rally Ahead of Big Earnings Week

Key Concepts

• Technology Sector Performance: Re-acceleration of growth, top quartile historical performance, increased valuations.
• Bubble Debate: Distinction between stock bubbles (fundamentals vs. price) and sector bubbles (investment in future technology).
• Historical Comparisons: Tech wreck of 2000 vs. current market, relative valuations, operating margins.
• Bubble Indicators: Capital expenditures (CapEx) relative to sales or free cash flow.
• Earnings Durability: High valuations as predictors of future growth.
• Sector Rotation: Shift from defensive sectors to economically sensitive sectors like technology.
• Tailwinds for Tech: Federal Reserve cuts, tax cuts, lower oil prices.
• Global Earnings Trends: US earnings accelerating, Europe and emerging markets decelerating.
• Valuation vs. Performance: International stocks being cheap but historically underperforming.
• Private Market Influence: Role of private markets in public market dynamics.
• Credit Market Indicators: High yield credit spreads and VIX as measures of market stress.

Technology Sector Performance and Valuations

The technology sector has seen a re-acceleration in its growth, returning to the top quartile of its historical performance. This is occurring alongside an increase in valuations, which are also back in the top quartile of their historical range. Historically, for the past 20 years, an environment of expensive valuations coupled with high growth has been a better predictor of market performance than lower growth with lower valuations. This suggests that high valuations can be a positive predictor of future, more durable earnings growth than investors might anticipate.

The Bubble Debate: Stock vs. Sector

A distinction is drawn between a "stock bubble" and a "sector bubble." A stock bubble is characterized by prices and valuations rising without supporting fundamentals. In contrast, a sector bubble involves an entire industry investing heavily in a technology with the expectation of future returns on that investment.

Historical Context: The Tech Wreck of 2000

Comparing the current situation to the tech wreck of 2000, it's noted that while both periods exhibit high growth and high valuations, there are key differences. In 2000, relative valuations were approximately 70% higher, and operating margins for the technology sector were negative. Currently, technology sector operating margins are not only positive but are increasing. This suggests that current high valuations might be justified by underlying fundamentals.

Bubble Indicators and Fundamental Strength

When examining bubble indicators like Capital Expenditures (CapEx) relative to sales or free cash flow in the technology sector, nothing appears anomalous. While nominal numbers are significant, free cash flow and sales are also robust, supporting the notion that high growth is matched by strong fundamentals.

Key Data Sets for the Tech Sector

The primary data sets being watched for the tech sector involve the shift between economically sensitive sectors (technology, communication services, consumer discretionary) and defensive sectors (consumer staples, health care, utilities). The recovery of median earnings for the first time in nearly three years is seen as a positive setup for economically sensitive sectors like technology, even though technology has already performed well. The durability of the earnings story is expected to broaden out.

Positive Tailwinds for Technology

Several tailwinds are positively predictive for the technology sector:

• Federal Reserve Cuts: Anticipated and ongoing interest rate reductions.
• Tax Cuts: Existing tax cuts that are expected to yield benefits through 2026.
• Lower Oil Prices: These act as a form of tax cut, with technology being the sector that historically outperforms most significantly after such a reduction. Lower oil prices can reduce costs, improve margins, and potentially lower inflation, which in turn increases multiples.

These factors collectively suggest more tailwinds for overall earnings growth, which is bullish for economically sensitive sectors like technology.

Global Earnings Trends and US Leadership

From a global perspective, earnings growth is occurring worldwide. However, there's a notable shift in trend over the last 4-6 months. Previously, international markets were accelerating while the US was decelerating. Now, US earnings, particularly led by technology, are accelerating, while European and emerging market earnings are decelerating. This shift presents a better risk-reward profile for markets, despite US stocks being more expensive.

Valuation vs. International Market Performance

While international stocks have been cheap and have outperformed year-to-date, historical data since 2010 (over 15 years) shows a 0% probability of outperformance for international markets. This highlights that valuations don't always dictate future performance, and stocks can be cheap or expensive for valid reasons. Valuations often correctly predict the durability of earnings growth. Therefore, US leadership in earnings is currently a significant factor.

Private Market Influence and Credit Market Stress

The importance of private markets in underpinning public market dynamics is acknowledged, with companies like OpenAI being mentioned as examples. From a data perspective, public credit markets are key to understanding what is being discounted. While specific insights into private credit markets are not available, a negative setup is indicated when there is more stress buying in high yield credit spreads than in the VIX or equity valuation spreads. Currently, credit spreads are well-contained, and there is more fear in the equity market. This suggests a potential for the market to "climb the wall of worry."