Rotation out of tech is not game over for the rally

After reaching record highs, the S&P 500 suffered a sharp sell-off on Thursday and Friday, to close 2.3% lower on the week. Rotation out of technology stocks was the cause of the sell-off, with the tech-heavy Nasdaq declining by 3.3% on the week. From Wednesday’s peak to Friday’s intra-day low the Nasdaq lost almost 10%, before recovering into the close. The Russell growth index fell 6.4% over the two days, while the Russell value index dropped by only 2.2%.

The sell-off raises the question whether the time has come to sell tech stocks. But our view is that the move does not mark the start of a renewed decline in tech similar to March:

The sector is expensive, but not in a bubble.

• The US tech sector has climbed to its highest post-dotcom valuations, with IT trading at 27x consensus forward EPS estimates, up around 22% from the beginning of the year. But, using the Nasdaq composite as a proxy, valuations are still well below levels seen at the height of the dotcom bubble of the late 1990s levels, when the index forward P/E rose above 70x. In our view, the IT sector looks appropriately valued relative to other sectors given current expectations for future cash flows and discount rates.

Option-related selling exacerbated the sell-off.

• The equity rally from the March lows has been concentrated on a few big tech names. Recently, a few large institutions as well as retail traders have shifted from buying the stocks to buying out-of-the-money call options in the individual names. Option-related trading doesn’t normally dominate flows, but daily single stock call option volumes in these tech names increased by five to 10 times compared to their normal levels in the last month. To hedge their price exposure, option sellers needed to buy more of the underlying stocks as tech rallied, but conversely needed to sell into a declining market when the market started to fall on Thursday.

A correction need not signal the end of the rally.

• Economies are in the early stages of a recovery, while central banks continue to support markets with low rates and asset purchases. As a result we are inclined to view the sell-off as a mid-cycle correction rather than the end of the rally. Over the past five years, we've witnessed a number of corrections in the global tech sector. Typically, these have led to 10%–12% peak-to-trough pull-backs, followed by a strong 20%+ rebound in the following six months. Assuming a similar correction in this instance, this would take the global tech sector's forward 12-month P/E back close to 25x. This P/E level is by no means cheap but it is still reasonable, in our view, considering the 20%+ earnings growth expected for tech companies over the next 12 months.

Put into context, the decline over Thursday and Friday means the Nasdaq has only reversed the gains of the previous two weeks. We could yet see renewed pressure on positive vaccine news or reopening momentum, since growth companies are more digital, virtual, and leveraged to stay-at-home trends. But overall, we remain positive on stocks, backed by Fed liquidity, attractive equity risk premiums, and an ongoing economic recovery. We also see scope for positive medical developments and further stimulus packages to aid the recovery.

However, the sell-off reinforces the need to rebalance tech portfolios by diversifying beyond mega caps, a course of action we have been recommending for several months. Investors should consider themes like technology disruption, which includes enabling technologies such as 5G, laggards such as digital advertisers and electronic payment providers, and potential turnaround opportunities in 2021. In addition to rebalancing toward themes accelerated by COVID-19 we also recommend gaining exposure to companies likely to benefit from a green recovery.

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