It’s been a long December for tech stocks.
The Nasdaq is down 8% this month and is down 32% year-to-date. That sets the tech-heavy index for the worst December decline since the dotcom bubble burst two decades ago.
Technology stocks have underperformed for many reasons.
First, there is the unfavorable macroeconomic environment with global economic growth. As GDP has historically declined, so has the performance of the economic technology sector.
Second, there is the hawkish policy of the Federal Reserve. Interest rates have risen sharply this year, leading to a decline in the valuations of the wealthiest companies — many of which reside in the technology sector. In fact, the Russell 1000 Value Index is down 8% year over year, while the Russell 1000 Growth Index is down 29%.
In 2023, will macro and currency forces continue to pressure the tech sector? Time will tell, but the basic view is not encouraging.
The S&P 500 Information Technology sector currently trades at 21 times earnings, compared to 17 times for the broader S&P 500. . But that is not the case.
According to Bloomberg forecasts, technology is expected to increase earnings by -0.6% in 2022 and 3.5% in 2023. These mixed growth rates leave the S&P 500, which is expected to increase revenue by 5.3% in 2022 and 2.7% in 2023.
In addition, technology investors face another important problem that is rarely discussed, and that is: the leader of the bull market often becomes the target of the next round..
Bear Markets usually bring new leaders
In the past thirty years, the US market has experienced three major market booms. Interestingly, the top three sector leaders have rotated with each passing cycle.
First, there was the bull market of the 1990s, led by the Information Technology sector’s +1,690% price return. Second and third place in that decade was Financials (+608% and Consumer Discretionary +442%).
After the bull market of the 1990s there was a bear market (3/23/2000 – 10/09/2002) in which the technology sector lost 82% compared to a 47% loss for the S&P 500.
Then, in the next bull market (10/09/2002 – 10/09/2007), the technology sector had the fourth best return. Meanwhile, the Financials and Consumer Discretionary sectors also lagged behind bulls, ranking 7th and 8th out of ten S&P 500 sectors.
The bull market that lasted between 2002 and 2007 has found a new leader. This cycle has particularly favored investment in natural resources. The three largest sectors are Energy, Utilities and Materials.
And how did these top sectors fare in the next bull market (3/9/2009 – 1/3/2022)? Not very good. All three were low fives, with the energy in the caboose.
Why does field leadership change every cycle?
There are basic and psychological reasons why the scene rotates.
Basically, it’s important to remember that all business cycles come to an end. In the bull season, the hottest sectors see overinvestment, which causes companies operating in the sector to sell at higher prices. Most of the excesses and valuations subside during bear markets, but these two forces may remain for years and still weigh on the secular return profile.
Psychologically, it is important to remember that all investors have a ‘loss’ bias – meaning that we hate losses more than we enjoy high levels of gains.
After the bear market, many investors are fighting the final battle for the next round. They remember which sectors and stocks are the most damaging to them, and try not to repeat those mistakes. Sectors that have benefited greatly from bull cycles often become overvalued assets. As the cycle turns, these sectors become primary sources of income as investors become more defensive during bear markets.
For example, the dot com industry became a laughing stock after the Tech Bubble burst in 2000. And many producers endured ten years of marginal returns between 2010 and 2020.
So far this year, the S&P 500 Technology sector is down 28%. Many tech bellwethers, like Tesla, are down even more (ie 65%). The magnitude of these losses will leave a stinging impression that lingers in the minds of investors for years to come.
Which sectors are poised to become new leaders?
We are currently in the first sticky bear market since 2008. No one knows where or when the bottom of the market will occur.
But what we do know is that every bear market in history has been followed by a bull market. So, instead of making wild predictions about when the economy will recover, or predicting when the Fed will cut interest rates, investors would be better off making sure their portfolios are well positioned for the next bull market.
Currently, I manage a barbell portfolio for clients. Since the economic growth is likely to continue in the first half of next year, I think it makes sense to play defensive by the sectors that are in excess of recession such as Health Care, Utilities and Consumer. Staples. Based on history, these sectors should hold up well in part of a bear market.
Once we cross over to the next bull market, I want a cyclical appearance outside of my defensive range to complete the barbell. Since the Technology, Consumer Discretionary and Financials sectors have led during previous bull markets—and we know that the top three don’t repeat often—I want to look outside of those sectors.
I think 2020 will be a reflationary decade that favors companies with tangible assets. Sectors that held back in the last bull market and now seem like logical candidates for the next cycle are Energy, Materials, and Industrials.
To offset the overweight in our portfolio, we are very underweight in the technology sector. Despite this year’s turmoil, the technology sector still represents 20% of the S&P 500. That may be a problem for passive investors, but it provides plenty of capital for investors. active investors they can reinvest in other, more promising sectors.