IYW - IYW: Economic Growth And AI Momentum May Outweigh High Valuations

2023-08-14 13:01:00 ET

Summary

• The iShares U.S. Technology ETF has seen high returns but recent price increases have brought valuations to significantly high levels.
• Macroeconomic and tech sector fundamentals support the continuation of the upward trend.
• Now is not the right time to sell because the combination of improving macroeconomic conditions and strong AI momentum will outweigh the high valuations.

The shareholders of the iShares U.S. Technology ETF (IYW) earned exceptionally high returns in the first seven months. However, around a 50% price increase has brought valuations to a late 2021 level, where the tech sector saw one of the major price corrections. Valuations, along with some other factors, have already created some volatility this month, with shares falling more than 6% from recent highs. The question here is whether the selloff signals the beginning of a major price correction or another bear market. Although it’s not possible to predict market behaviour with high accuracy, I believe there is a low risk of a significant price correction. My answer is based on a number of factors, including differences in macroeconomic and tech sector fundamentals when compared to 2022. Therefore, it may be prudent to hold shares and focus on long-term gains.

Macroeconomic Fundamentals Support Uptrend

The risk of a severe recession, extremely high valuations, 40-year-high inflation, and one of the fastest rate hike sprees all contributed to the bear market in 2022. Besides high valuations, there is currently no other legitimate reason that can lead to a significant price selloff. Additionally, improving economic conditions and the declining risk of recession are the most important factors for the continuation of the tech sector’s upward trend. The US GDP increased higher than expected in the first half, with the Federal Reserve Bank of Atlanta forecasting 4.1% growth for the third quarter. If actual growth exceeds 3.2%, it will be the highest in the previous six quarters. Moreover, strong job market expansion and historically low unemployment rates have also ruled out the high risk of a recession. The Fed's pivot could be the second reason for the extension of the uptrend. The CME FedWatch Tool shows that the Fed will keep the benchmark rate unchanged in September, with a rate cut in early 2024. Overall, a significant drop in inflation and a strong economic recovery suggest that the Fed is nearing a soft landing, which supports investments in high-beta stocks and ETFs like IYW.

Tech Sector Outlook and IYW

FactSet data show that the information technology sector ranked first in the June quarter in terms of earnings surprises and second in revenue beats. Consequently, tech sector earnings moved into positive 1.1% growth, exceeding forecasts for negative 3.5% growth. The sector’s future fundamentals also look robust considering economic recovery and AI momentum. In particular, AI is likely to generate significant revenue for tech companies involved in offering software, chips, and other products to power AI technology. The AI market size could reach $1,811 billion by 2030, a 37% compound annual growth from its $187 billion market value in 2023.

As the tech sector is distributed into many industries, it might be risky to bet on a single stock from any industry to fully capitalize on the impact of economic growth, AI hype, and improving online advertising. I believe the iShares U.S. Technology ETF is one of the best options for capitalizing on potential gains and lowering the risk factor. The ETF tracks the performance of 136 large-cap tech stocks. Its stock holdings range from the world's largest technology behemoths to the most advanced chipmakers, software application developers, and cloud computing service providers.

For example, Apple (AAPL), the tech behemoth, is likely to benefit from economic growth and declining inflation. This is because economic expansion and low inflation increase consumers' ability to spend more on phones and other products. On the other hand, rising demand for AI is likely to open new revenue streams for software application developers. As of the end of June, software companies accounted for 46% of IYW’s portfolio weight. For instance, shares of Microsoft (MSFT) have risen nearly 40% year to date on expectations that it will lead the AI market. Early in 2023, it made a sizable investment in OpenAI, and it was among the key players in developing ChatGPT. The company has also introduced generative AI tools such as Copilot across its portfolio. Goldman Sachs analyst Kash Rangan anticipates that Copilot alone has the potential to generate billions of dollars in revenue each year for the company. In the June quarter , its intelligent cloud segment, which includes many of Microsoft's current AI offerings, saw 17% revenue growth compared to the year-ago quarter.

Similarly, Adobe Inc. ( ADBE ), a creative and management software application company, experienced a share price rally of 50% year to date due to optimism over its AI features. In recent months, the company has released a number of new AI products while powering existing products with AI technology. Shares of Salesforce ( CRM ) also surged 60% due to confidence in the company's strategy of integrating generative artificial intelligence into every aspect of the business. It introduced various AI solutions and integrated them into its existing products, such as the Sales Cloud and Service Cloud.

Chipmakers in the tech sector, which account for 22% of IYW's portfolio weight, have also seen robust demand for chips that can power AI in data centers. Broadcom (AVGO) is expecting AI to make up more than a quarter of the company's semiconductor revenue by 2024. NVIDIA ( NVDA ), whose chip is used in developing ChatGPT, is anticipated to earn $300 billion in AI-specific revenue by 2027. Alphabet's CEO, Sundar Pichai, attributed 28% of June quarter revenue growth in its cloud business to the company's new AI services and offerings. Pichai also mentioned that the introduction of AI offerings is expanding its customer base. Moreover, the company has also benefited from improved online advertisements, thanks to strengthening macroeconomic trends. In the June quarter, its advertisement revenue came in at $58 billion, compared to $56 billion in the year-ago period.

Risk Factors to Consider

It's important to understand that tech-focused stocks and ETFs offer high rewards but also carry high risks. The SA's quantitative analysis also provided a negative C grade on the risk factor, suggesting that IYW poses a significant level of risk. The ETF exhibits high volatility, a high standard deviation, and a higher concentration in the top ten holdings.

Besides all this, higher valuations are one of the biggest risk factors for the tech sector. Valuations have risen to levels last seen in late 2021 when a major price correction occurred. The tech sector has a long history of trading at a premium compared to the S&P 500. However, the premium now looks significantly higher compared to the historical average. IYW’s majority of the top 10 holdings look expensive, but Apple, Microsoft, and Nvidia, in particular, are trading at significantly high forward price-to-earnings ratios. For instance, Apple’s forward PE of 29 times is above its 5-year average of 25 times and the sector median of 27 times. In addition, their price-to-book and sales ratios make them appear more expensive .

In Conclusion

It is true that valuations are extremely high, and a price correction is possible. However, I believe that the combination of improving macroeconomic conditions and strong AI momentum will outweigh the high valuations. Therefore, as there is a low risk of a bear market or a significant price correction, it is not the best time to sell IYW shares. Indeed, investors may increase their existing positions because the exponential inflow of AI-related revenue and earnings is expected to drive the entire sector to new highs in the near and long term.

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