The tech sector has had a bumpy ride this week, thanks in part to Apple, which reached another record closing high on Monday and then tumbled on Tuesday. The iPhone maker is more than 16% of the tech sector’s weight, so whatever happens to its stock has a significant impact on the sector as a whole.
We’re already within a month of the beginning of the first-quarter reporting period, if you can believe it, so Wall Street is starting to get together its estimates and really look closely at the numbers. Semis has been a key driver of the tech sector’s outperformance over the last year or so, and that’s expected to continue, although there is a huge problem. Estimates might be too high because the Street hasn’t reduced its estimates like it usually does going into earnings season.
Tech sector roars ahead
In a research note dated March 24, CFRA Investment Strategist Lindsey Bell note that the tech sector’s fundamentals have been improving steadily over the last several quarters, but despite that, its valuation is roughly in line with its historic average. She added that the S&P 500 is trading at a premium to its historic average, although she sees several factors that might continue to support upside for tech this year.
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A lot has changed since early 2016 when the tech sector was the second worst performer in the S&P 500 through the end of June, falling 2.6%. The only sector that did worse than Technology was Financials with a 5% decline.
Tech sector earnings flip to positive territory
But as the year went on, tech earnings improved and then began growing later in the year. Then in August, the sector started outperforming the S&P in price as its strong results gave it a boost. During the second-quarter reporting period, the tech sector posted results that were much better than expected, driven by especially weak sentiment leading up to the reporting season.
The sector ended the second quarter earnings reporting period with a 2.2% increase in earnings, which was much better than the decline that had been expected going in. According to Bell, that was the biggest beat for the tech sector in two years and the second-biggest beat of all the sectors in the S&P during that quarter. The sector beat estimates again by wide margins for the third and fourth quarters, she adds.
Bell also noted that the tech sector has come out ahead of initial analyst expectations by an average of nearly 5 percentage points over the last two years, which was better than the average beat in the S&P 500. Over the last three quarters, however, the sector’s average beat rose to 6.2 percentage points.
Tech sector enjoys strong fundamentals
While fundamentals have been a key driver of the sector’s outperformance, Bell added that tech has also benefited by the sector rotation that’s been going so far this year. For the first quarter, the sector is expected to post strong earnings growth of 16.3%, according to S&P Capital IQ, giving tech the second-best growth rate in the S&P after only energy, which is cycling big losses a year ago. Bell also added that this will be the third consecutive quarter that the tech sector will be one of the top three sectors for growth, which hasn’t happened since 2012.
The two tech subsectors that are expected to lead the way in growth are semis and Internet and software services.
Semis in particular boosted the sector’s growth last year, and Bell explains that in the first half of last year, Wall Street greatly cut its estimates for semis because of the disruption in Apple’s supply chain. This made it quite easy for chip makers to beat estimates.
Semis flying high
The problem was resolved later in the year, bringing semis back to high-20% earnings growth rates, which was well ahead of what the Street was expecting at that time. For the first quarter, the Street is expecting semis to post a 38.7% increase in earnings, as the year-ago period poses an easy comparison. Other positive catalysts for the subsector include merger and acquisitions, higher content per device for memory, and strength in the Internet of Things and data centers.
However, Bell reports that the S&P Capital IQ Consensus Estimate for the tech sector hasn’t moved much since December, which she says is concerning because usually, Wall Street reduces its estimates as earnings season approaches. She adds that the Street has cut its estimates for the other sectors as is customary.