The market's love-hate relationship with tech

Key takeaways

• The bull market remains intact, but investors' relationship with the technology (tech) sector has become increasingly complicated.
• Tech has undergone a healthy reset in price and valuation after an exceptional run. It is in the midst of its fifth double-digit pullback of this bull market.
• The correction appears to be maturing, though it has been both shorter and shallower than the average of the four previous pullbacks in this bull market, suggesting it may have further to run.
• Earnings trends remain supportive, with tech estimates continuing to push toward new highs and AI infrastructure demand holding firm. Valuations have reset to the low-end of the recent range.
• Credit spreads within tech are widening and warrant monitoring, though the move appears more cautionary than alarming at this stage.
• Near-term bumpiness is likely to persist, but the weight of the evidence suggests the primary uptrend for tech remains in place and the risk/reward has improved.

What happened

Tech remains at the center of this bull market, but investors' relationship with the sector has become increasingly complicated. After driving much of the market's advance, tech has recently come under pressure even as earnings continue to move higher and AI-related demand remains robust. The key tension is that concerns surrounding rising AI-related capital expenditures have begun to weigh on parts of the sector.

Back in early June, we highlighted that technology appeared due for a pause after becoming stretched on several measures. The sector rallied 47% from the March lows, dramatically outpacing the broader market.

Indeed, tech was the only sector to outpace the S&P 500, an unusual feat, with the next-closest sector lagging by roughly 30 percentage points. Moreover, the Philadelphia Semiconductor Index posted a quarterly gain of 88%, the strongest in its history.

• Since the early June peak, tech has corrected approximately 11%, marking its fifth double-digit pullback of the current bull market.
• Notably, this has also been the shallowest correction of the previous four, with prior declines ranging from 12% to 26% (average 18%) and lasting between one and five months versus just under two months currently.
• This suggests the reset is maturing, though it may have further to go.

Our take

Our work suggests this reflects a healthy reset rather than a change in the longer-term trend.

Markets often behave like a rubber band. When leadership groups become overly extended, periods of consolidation help bring prices, expectations, and sentiment back into balance. That appears to be happening now.

The good news is that several excesses have now been worked off:

• Tech's forward P/E has declined to 22x, down from an October peak of 32x, representing a valuation reset of about 30%.
• The sector's valuation (forward P/E) premium versus the S&P 500 has narrowed to 13%, down materially from the nearly 50% peak seen earlier in the bull market.
• Moreover, tech's earnings estimates continue to push to new highs, significantly outpacing the broader market.
• Recent earnings results suggest that spending on data centers, computing power, and related infrastructure continues to support revenue and earnings growth across parts of the technology ecosystem.

Keep in mind that despite pullbacks along the way, tech is still up roughly 220% since the bull market began, more than double the gain of the S&P 500.

Credit – A key risk to watch

One area that has caught our attention is credit.

Tech-related credit spreads have been moving modestly higher, suggesting investors are demanding greater compensation for risk.

Investors are increasingly focused on whether rising AI-related capital expenditures will require additional borrowing and weigh further on near-term free cash flow generation.

We do not view this as a major warning signal today, but it bears watching and reinforces our expectation that the path forward is likely to be volatile.

Bottom line

The tech correction has created discomfort, but it is also creating a healthier setup with an improved risk/reward.

The correction appears to be maturing, though it has been both shorter and shallower than the average of the four previous pullbacks in this bull market, suggesting it may have further to run.

Rising credit spreads for tech companies remain important to monitor.

Still, the weight of the evidence remains constructive. With valuations substantially lower, earnings estimates continuing to advance, and AI-related demand remaining firm, the recent weakness appears to be helping bring prices, expectations, and fundamentals back into balance.

As a result, we maintain a favorable long-term view on tech. At the same time, given the increasingly rotational market backdrop, we are balancing that stance with positive views on small caps and select cyclical and defensive sectors, including industrials, energy, financials, and healthcare.

As always, we will continue to follow the weight of the evidence, keep an open mind, and update you as our views evolve.