XLK: Sitting On The Sidelines For Now On Mixed Outlook

Introduction

The Technology Select Sector SPDR Fund ETF (NYSEARCA:XLK) is a low-cost ETF focused on tracking large cap technology names within the S&P 500. I am a long-term bull on technology as an investment case, as technology is a fundamental driving force behind economic growth. Its impact cannot be understated, an OECD paper described technology’s impact as the following:

“It is taken as axiomatic that innovative activity has been the single, most important component of long-term economic growth” (OECD)

As a result, tech has historically been the highest performing sector due to its abundance of high quality growth names.

What to Like

With Q1 earnings season almost completed we see quite a dispersion among S&P 500 sectors. Technology has been one of the best performers, posting year-on-year earnings growth of 24.2% vs. index level growth of 7.6%. However, if we strip out numbers from NVIDIA Corporation (NVDA) that figure falls to below 11%, so earnings numbers are strong but somewhat flattered by an outlier effect.

Looking at the performance vs. consensus expectations heading into earnings season, we can see that the Tech sector had the highest ratio of earnings beats. Close to 89% of companies in the sector reported numbers exceeding analyst expectations. Tech sector earnings look to be outperforming both the overall market and sector-specific expectations.

Expense ratio

One aspect of XLK that is unequivocally a positive in favor of the fund is the market-leading expense ratio and liquidity. As seen below we see the fund charges a measly 9 basis points as an expense ratio, this compares very favorably to competing products such as BlackRock iShares U.S. Technology ETF (IYW) which charges 40 basis points for a similar product.

A difference of 31 basis points seems trivial, but compounded over time, this extra cost can create a drag on portfolios. As I’ve shown below, for a long-term investor, in over 30 years the difference in ETF expense ratios results in close to ten thousand dollars of lost earnings. This highlights the benefit of low-expense ratio products in the ETF space. I see tech sector earnings growth and the low ETF expense ratio as the two largest positives currently for XLK.

What Not to Like

A clear risk to the highly valued tech sector and stocks generally, is the potential for a higher for longer interest rate scenario. Earlier in the year, markets were convinced we would see multiple rate cuts in 2024 with the earliest cuts priced for March. However, inflation has remained stubbornly above the Fed’s target of 2% and the jobs market has remained hot. As a result, rate cuts have generally been priced out, with the current wisdom suggesting just two cuts in 2024.

Given we came into the year pricing for six or even seven cuts, I don’t think we should assume two cuts with any confidence. There clearly remains a risk that both inflation and the jobs market stay hot, resulting in rate cuts being further priced out or pushed back in time. Bond market pricing has drifted higher over the past three months with the two-year treasury briefly flirting with 5% levels again before settling back down somewhat.

Speaking with Bloomberg this week, JPMorgan Chase & Co. (JPM) CEO Jamie Dimon had the following to say:

“Stocks are very high, and I think the chance of inflation staying high or rates going up are higher than people think” (Jamie Dimon)

Concentration

An aspect I do not like about the ETF is the level of concentration. Two names, Apple Inc. (AAPL) and Microsoft Corporation (MSFT) make up over 43% of the fund and over two-thirds of the fund is concentrated in the top ten holdings. This means we end up with significant exposure to names at the top, which I do not see as favorable for investors.

As an example, the fund holds c21% in Apple and only c2% in QUALCOMM Incorporated (QCOM). Within an asset allocation framework, I do not see the merit in holding ten times the weight in Apple vs. Qualcomm, given what I perceive to be a more attractive valuation and growth outlook for the latter. This can be evidenced in the wide difference in PEG ratios. Simply put, if we were buying individual names a 10x concentration in Apple would be very difficult to justify in my view.

Valuation

Assessing the valuation of the tech sector I find it hard to be bullish. Historically interest rate cuts have lowered the discount rate for equities, which in turn leads to a multiple re-rating and a higher P/E. Given where valuations currently sit, a jump higher in the P/E ratio would be moving into bubble territory. This would benefit investors in the short term as prices move up, but I don’t think any prudent investor desires stocks to go into a bubble. On the flip side, if rate cuts do not materialize it could be difficult for tech stocks to maintain current multiples given how far they sit above historic averages.

The Tech sector P/E currently sits at close to 33x which is more than two and a half standard deviations above the ten-year average and four standard deviations above the 20-year average.

With valuations sitting at pretty extreme levels relative to history, and little opportunity for a sustainable re-rating, I cannot justify current levels as a good entry point for investors. As recently as the start of 2023, investors were presented with opportunities to pick up shares in the low-20s P/E range. I think patience is the best course of action from here.

When we look at the relationship between the starting point of the P/E ratio and subsequent ten-year forward returns, we can see a clear relationship indicating that chasing a high P/E will most often lead to poor subsequent performance.

Conclusion

In conclusion, I think the best course of action at present for investors is to HOLD. The outlook in my view is mixed as robust sector earnings are offset against potentially sticky inflation and valuations there look very expensive. I am a long-term bull in the tech sector, but with valuations sitting more than two and a half times above the ten-year average, I do not see this as an attractive entry point.

The only condition under which I would be buying at present is as part of an ongoing dollar cost averaging approach, I would not recommend lump sum purchases at present.