Tech ETFs Retreat: Pullback Ahead?

Volatility may still be restrained when it comes to the stock market, but it's made a sudden re-emergence in at least one key sector. Technology stocks were pummeled on Friday, and then again on Monday, after some analysts questioned whether valuations for the group may have become too stretched.

The $17.6 billion Technology Select Sector SPDR Fund (XLK) dropped more than 3% over the two-day period, bringing its year-to-date return down to 15.6%. Even after the decline, tech—which makes up almost 23% of the S&P 500 by market capitalization—is still the best-performing sector of the year.

But in light of the latest move, some are now pondering whether there is more room to go on the downside―and if so, whether the broader stock market will come along for the ride.

YTD Return for XLK

Analyst Warnings

In that camp is Bank of America, which recently warned that tech may be trading at its highest P/E multiple relative to the broader market since the 2000 internet bubble. BofA also said that large-cap active fund managers are the most overweight on the sector they have ever been, a signal that tech stocks may have gotten ahead of themselves.

"Based on EV/Sales, which would not be impacted by accounting differences such as the inconsistent treatment of stock-based compensation—a large expense for many Tech companies that we estimate could understate Tech's current P/E by as much as 10%, Tech trades at its highest relative multiple since the Tech Bubble, and is trading well above average even when excluding the Tech Bubble," wrote the bank in a report from earlier this month.

Bank of America isn't the only one. In the past few days, Goldman Sachs got investors chattering after it released a pair of reports highlighting the big run-up in tech stocks.

‘Valuation Air Pocket’

Goldman said that five tech stocks―Facebook, Apple, Amazon, Microsoft and Google (FAAMG) ―account for 37% of the S&P 500's year-to-date gain despite only making up 13% of the index. The investment bank argued that a "valuation air pocket" had developed as a result of the uninterrupted run-up in these mega-cap tech stocks.

Investors have been gravitating toward these stocks due to their strong balance sheets and perceived lower levels of risk. However, the Goldilocks scenario for growth and interest rates will eventually end, potentially leading to a pullback in the group, according to Goldman.

"The unexpected mix of healthy growth and declining rates represents a Goldilocks scenario for U.S. equities," explained Goldman. "However, just like in the fairy tale, this perfect scenario is unlikely to last."

Timing Uncertain

Regardless of one's views on the valuations of tech specifically and the market generally, a pullback shouldn't be surprising. Corrections are as inevitable as the rising sun. The fact that there hasn't been a 5%-or-greater sell-off in the S&P 500 in more than seven months means that, at the very least, one of those routine stock market road bumps is long overdue. 

Tech valuation concerns may be the catalyst that spurs that correction―or maybe not. In March, April and May there were a few notable one-day drops in the market tied to political events (such as the initial failure of the House health care bill, and the Comey memos about Trump), but none of them lasted, and the market quickly recovered to new highs.

A correction may be inevitable, but there's no telling exactly when it will happen or what will cause it, especially in the current period of record-low volatility. All investors can do is position themselves to withstand any forthcoming turbulence.

Contact Sumit Roy at [email protected].