DNY59
It’s pretty hard to avoid value in the hard-hit Technology Select Sector SPDR ETF (NYSEARCA: XLK) when expectations are rising at the end of a bear trend due to increased odds about the Fed’s pivot. Other factors such as Steady earnings, investor confidence in risky assets, and a sharp drop in valuations suggest that tech stocks are already down or have limited downside left. Additionally, it appears that high rates, economic slowdown, and panic selling have priced into the sector’s performance. Therefore, I believe that now is one of the best times for bold investors to invest in tech-focused ETFs for heavy long-term returns.
Downside Risk is Limited
CNN.com
US stocks suffered a rare sell-off in the first half of 2022, which continued into the third quarter and reached fresh year-to-date lows at the start of the fourth quarter. However, after hitting new lows in mid-October, investor sentiments improved sharply in the following weeks amid optimism over the Fed’s pivot. This is also reflected in CNN’s Fear & Greed index. It moved from an extreme level of fear last month to a neutral range last week, and then to a level of greed this week. It’s likely that tech stocks could begin to recover at a faster pace once investors see signs of ease in the Fed’s interest rate hike, which could happen after the November meeting. The growth rate may drop to 0.25 to 0.50 bps in December before reaching a terminal level of 4.60% in 2023.
The Fed also appears to be under tremendous pressure on its rate hike policy, which could force them to reconsider their aggressive stance. This is because rate hike policy has so far failed to significantly tame inflation, which currently hovers around 8%. Meanwhile, the strategy has severely damaged the US economy and raised the risk of a recession in 2023. According to The New York Times, President Biden met with economists and policymakers last week to assess the possibility of a UK-style meltdown or 2008- style financial stress due to aggressive rate hike policy. Prominent Wall Street names like Cathie Wood, Elon Musk, and many others have also expressed concerns over the Fed’s tightening policies and the possibility of a deflationary burst. Cathie’s point about the deflationary burst is worth considering. According to him, energy and agricultural prices are rising due to Russian aggression, and the Fed should not raise rates to control them. Prices of other commodity groups have fallen sharply from their recent highs due to a breakdown in demand. Also, he warned that ballooning retail inventories could cause negative inflation.
Why XLK Rides Best in Potential Rally?
When markets are likely to face uncertainty or a bearish trend, bet carefully on low-beta stocks, but these stocks do not perform well during a recovery phase. Before the recovery phase, it may be prudent to invest in quality growth stocks or ETFs. The SPDR Technology Select Sector ETF is one of the best high-beta ETFs that can help investors make big returns during the recovery phase and generate stable returns over the long term.
I favor the Technology Select Sector over communications or consumer cyclical ETFs because the latter are more sensitive to economic conditions. Right now, the S&P 500’s communications sector is down around 40% and the consumer cyclicals sector is down close to 30%. The products and services they offer are not essential goods and their demand decreases when people have less disposable income. For example, Amazon (AMZN), the largest consumer cyclical stock, has lost nearly 40% of its market cap over the past twelve months due to slowing economic growth and high inflation. The company missed third-quarter revenue estimates and expected fourth-quarter earnings between $140 billion and $148 billion, significantly below the consensus estimate of $155.37 billion. Also, operating income is expected to be between $0 and $4B, down from $24 billion last year. Similarly, several other major consumer cyclical companies such as Alibaba ( BABA ), eBay ( EBAY ), Nike ( NKE ), and JD.com ( JD ) have warned of economic slowdown and deteriorating financial performance.
Meanwhile, shares of mega-cap communications giants such as Alphabet (GOOG) (GOOGL) and Meta Platforms (META) fell sharply after they reported lower-than-expected third-quarter results. However, the technology sector, and particularly the Technology Select Sector SPDR ETF, has shown resilience against headwinds.
XLK’s Top 10 Stocks (ssga.com)
While XLK’s portfolio consists of 79 stocks, its performance is driven by its top 10 holdings, which represent 67% of the portfolio. Surprisingly, the financial numbers of tech companies continue to grow despite the headwinds. Apple (AAPL), for example, topped the quarter in revenue and earnings estimates. In addition, the company posted 9% year-over-year growth in revenue as its earnings per share jumped to $1.27 from $1.24 last year. Market analysts believe that Apple has the potential to maintain high single-digit revenue growth and mid-single-digit revenue growth for many years.
Microsoft (MSFT), the second-largest stock in XLK’s portfolio, also beat expectations on revenue and earnings. Its top line grew 11% year-over-year while operating income rose 17% from the previous year. XLK’s portfolio includes a number of software companies, which together make up about 32% of the total portfolio. While software stocks have fallen sharply this year due to economic and interest rate volatility, their returns have been steady. I believe that when the market recovers, their earnings resilience will help them recover strongly. Further, IT services companies also show strong revenue growth prospects despite the volatility. In the September quarter, Visa (V) and Mastercard (MA), XLK’s fourth and fifth largest stock holdings, reported good results. ServiceNow (NOW) and Accenture (ACN) were also among the IT Services companies that beat analyst expectations. On the negative side, semiconductor stocks, which make up 18% of the portfolio, may weigh on overall performance. This is due to restrictions on chip shipments to China along with a slowdown in gaming and the PC market. Overall, the XLK portfolio has an expected average earnings growth rate of more than 13%, positioning it well for a sharp rebound in the market’s recovery.
Is This the Right Time to Buy?
After the energy sector, the information technology sector received the highest buy rating from analysts, according to FactSet data. Sixty-two percent of analysts rated tech stocks as buys. Also, with a price-to-earnings ratio of around 20 and a forward price-to-earnings ratio of 17, tech stocks appear in a buy zone.
Quantitative Score (Seeking Alpha)
Furthermore, with a quant score of 3.83, Seeking Alpha’s Quant system rates XLK as a buy. Besides risk, the rest of the four quant factors received strong ratings. Asset flows and momentum scores indicate limited downside potential and increased investor confidence. XLK’s expense ratio of just 0.11% makes it a great long-term investment.
In Conclusion
The downside is limited from here as stocks have already priced in negative events, while the Fed pivot will help boost investor confidence in high-beta ETFs like XLK. A significant increase in asset flows also indicates that investors are showing confidence in tech stocks. Furthermore, the robust earnings outlook not only supports valuations and share prices but also suggests that the sector can withstand wider economic uncertainty. Overall, investors looking for long-term growth should take advantage of the decline in XLK’s price.