Since last fall, technology companies have been helping pull the broader market higher. The S&P 500 technology sector, of which Apple (AAPL) makes up a significant part, has gained roughly 20% year to date and is up approximately 37% from last summer’s low. It’s no surprise, then, that many investors are wondering if the momentum will last.
In my opinion, while the technology sector still looks compelling over the longer term, it may be time for some investors to pare back their positions in the sector. The reason: Three factors are likely to conspire to slow the pace of technology gains in the near term.
Valuations: While valuations, both absolute and relative, are nowhere near the stratospheric levels reached at the peak of the late 1990s bubble, the technology sector no longer appears particularly cheap relative to the broader market. For example, U.S. technology companies are currently trading at a 55% premium (based on price-to-book ratios) to the S&P 500, close to the long-term average premium.
Excess Capacity: It’s hard to justify the current technology premium considering the slippage we’re witnessing in capacity utilization. This metric, a measure of how much of available manufacturing capacity technology companies are using, has fallen to 77% today from 80% in August. And the deterioration has been even worse in the semiconductor industry, where capacity utilization has collapsed to barely 71% today from nearly 86% in early 2011. This concerns me because higher capacity utilization is generally associated with more pricing power. To the extent that capacity utilization is falling, it suggests that companies in the sector – Apple aside – may actually have modestly less pricing power going forward.
More Muted Appetite for Risk: While I believe that the global equity market can grind higher in 2012, I do expect any future gains to be accompanied by more volatility and as a result, more risk aversion. Technology companies are no longer the riskiest sector of the market (that distinction now belongs to financials), but they still tend to be more sensitive to market volatility than more defensive sectors, such as healthcare and consumer staples. For instance, during the recent pullback that began in early April and lasted for a few weeks, the technology sector lost 6.5% from peak to trough versus a fall of around 4.25% for the broader market.
To be sure, there is still a likely bright long-term future for technology companies. The sector is still incredibly profitable, with a return on equity of around 34% versus 28% for the broader market. That said, for investors who bought in the fall and now find themselves with an outsized position in the sector, now is probably an opportune time to do a little trimming. As such, I recently downgraded my view of the U.S. and global technology sectors to neutral from overweight and I’m now advocating that investors maintain a benchmark weight in the sectors through the iShares Dow Jones US Technology Sector Index Fund (IYW) and the iShares S&P Global Technology Sector Index Fund (IXN).
International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments typically exhibit higher volatility.