Technology Sector Outlook: What Investors Can Expect | The Smarter Investor

The technology sector is once again the top-performing sector in the stock market.

This sector has gained more than 30% year to date, as measured by the Technology Select Sector SPDR Fund (ticker: XLK). As good as the performance of XLK has been this year, the exchange-traded fund’s rise was better last year when it enjoyed nearly a 50% gain.

Technology leading the way is not new, as this will be the third time in four years it has been the top-performing sector.

The last sector to stay atop the leader board this long was energy back in 2004, 2005 and 2007. Since then, energy has lagged versus other sectors. This year is no different as the S&P 500 Energy index, which represents the sector, has lost more than 40%.

Markets Don’t Repeat, They Rhyme

Examining the holdings of the XLK today, the largest allocations are tech companies, but there are three holdings in the top ten that are financial companies. Those are Visa (V), Mastercard (MA) and PayPal Holdings (PYPL). It may make perfect sense for these companies to be part of this ETF, but it may also raise a few questions.

For some, revisiting the importance of being a tech company may bring back memories of the dot-com era. Going back to 1999, technology was the leading sector by performance, as it was for much of the late 1990s. In 1999, XLK opened for trade and gained 66% that year.

To a certain degree, when technology does well, some traditional sectors will perform poorly. In 1999, the sectors that performed the worst were financials and real estate. In 1998, the energy sector was a laggard as well.

Fastforward to today, and some of the worst-performing sectors are energy, financials and real estate. Coincidence? Maybe, or maybe not.

Certainly, a diversified portfolio would have served an investor well after 1999, as the technology sector would face the headwinds of the dot-com bubble. Technology became one of the worst-performing sectors over the next several years, averaging a loss of 10% between 2000 and 2005.

I am not suggesting that we are on the thrust of the next period of underperformance in this sector, but it may be time to express a little caution.

Valuations

Leading up to the 2000s, price-to-earnings ratios for the technology sector were much higher than the average price-to-earnings ratios of the S&P 500. In fact, as a sector, the P/E ratios for technology would eclipse 60. Today, the average P/E ratio for many of the top holdings in the XLK is more than 30.

By comparison, many companies that comprise the finance sector, as measured by the Financial Select Sector SPDR Fund (XLF), have P/E ratios of less than 20. Those companies include Goldman Sachs (GS) and Citigroup (C). At last check, Goldman Sachs was still posting profits in the billions in a difficult year for many companies.

When technology started to lag the other sectors in performance after 2000, the leading sectors turned out to be consumer discretionary, health care and energy over the next few years.

Can a case be made for one of these three sectors becoming a top performer over the next year or two? Absolutely.

Both consumer discretionary and energy may benefit from a recovering economy. A move toward lower unemployment levels, as we saw before the pandemic, could act as an economic boost for traditional business models. Remember that the markets will not wait for rush hour traffic to return; they will react at least six months in advance and price securities accordingly.

Takeaway

Over time, diversification will prove to be the proper way to allocate a portfolio. In the past 20 years, we have seen multiple instances in which one sector was a top performer for a few years, only for that sector to end up being a laggard in the years that followed.

The health crisis has accelerated the use of some technologies, but this is the third time in four years that technology has been a leading performer. It may be worth diversifying a portfolio into other sectors, such as financials or industrials, in which companies generally have lower P/E valuations.

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