Don’t count the tech sector out

April 12, 2022

AFTER LEADING THE MARKET SURGE OF 2021, technology stocks have been at the center of volatility in 2022. On March 7, for example, the tech-heavy Nasdaq Composite Index entered bear market territory, down more than 20% from its all-time high last November 1.¹ Possible causes for the decline include tighter monetary policy and rising interest rates driving a correction in technology stock valuations. In addition, slower growth is projected among some of the technology-related firms that helped the world go remote during the pandemic and delivered very strong growth and earnings.

So, is it time for investors to take a break from technology? Hardly, says Brian Daley, Head of Equity Strategy in the Chief Investment Office for Merrill and Bank of America Private Bank. “Technology has become such a force that it’s almost impossible not to consider it in today’s increasingly digitalized economy,” Daley says.

For example, the four largest companies in the United States by market capitalization are all widely seen as technology companies.² “Leaving such a large and important sector out could add risk to portfolios,” Daley adds. Rather, current economic conditions call on investors to look a bit deeper into the technology sector and think carefully about which stocks can help them meet short- and long-term goals.

A more diverse tech sector

One challenge for investors is that the tech sector has become harder to define as its influence on the world has expanded, Daley notes. “If you go back to the 1980s or ’90s, sector composition was cleaner and more uniform. Technology was technology,” he says. “You didn't have internet and social media, e-commerce or cloud computing companies.” For investors, that meant a group of companies with roughly similar market qualities and characteristics. Today, different types of tech investments may present higher or lower risk in a portfolio.

These days, many of the largest tech firms, by the nature of their business, overlap with a variety of other sectors such as consumer discretionary, media and communications services. As such, these stable, profitable companies tend to reflect not just technology but the wider economy, Daley notes. At the other end of the tech spectrum are innovative companies exploring “moonshot” technologies such as nextgen batteries and renewable energy technologies, as well as 6G technology, the metaverse, virtual reality and the like. While some of these companies may not yet generate profits and thus carry higher risk in the current environment, they could also be future game-changers, says Daley.

Look for ‘profits over concepts’

Recent market volatility, driven by inflation, rising interest rates, monetary tightening and Russia’s invasion of Ukraine, favors high-quality, established companies whose stocks may be available at reasonable prices, Daley says. Similarly, “when it comes to investing in the technology sector, the current climate favors profits over concepts.” In other words, companies with proven track records and solid earnings visibility versus early-stage companies developing exciting new products or services that have yet to produce substantial earnings. Though some larger, established tech companies may seem overvalued, at a time of volatility and investor nervousness, “the stocks getting hit the hardest have been companies that don't have profits and therefore trade at very high prices relative to sales,” Daley says. Further, many of the larger, established tech companies have the financial strength to consistently grow their dividends and increase cash returned to shareholders over a market cycle.

Manage short-term tech-sector volatility

Investors with a relatively short-term horizon, such as those saving for imminent retirement, may want to review the types of technology companies they’re exposed to through their mutual funds or that they invest in directly. “You may want a higher proportion of high-quality, secular-growth leaders, such as industry-leading companies in software, semiconductors and cloud computing, that already have profits and generate a lot of free cash flow,” he suggests. “These are companies that likely can still grow their earnings even with the Fed’s tightening monetary policy.”

Such firms do still entail some risk, Daley notes. Some legislators have called for tighter regulation of big tech, which could affect stock prices. In the long term, though, these companies stand to benefit from underlying strengths in the U.S. economy, such as strong consumer demand, positive job numbers and strong corporate earnings.

Don’t abandon longer-term tech opportunities

Yet while favoring profits over concepts may be the portfolio choice for today, that doesn’t mean investors with a longer time frame should abandon promising ideas, Daley says. “In a balanced portfolio, there’s still room for emerging innovative companies, including small cap stocks that may one day help reshape the future,” he notes.

“You can still own these stocks, but your allocation has to be the appropriate size for your financial goals and objectives,” Daley says. Regardless of current market conditions, any portfolio decisions should be made based on a careful assessment of your personal priorities and goals, timelines, risk tolerance and liquidity needs, he adds. Your advisor can work with you to carefully analyze your portfolio to help ensure that you are properly diversified. Doing so can help you weather volatile times while staying invested for a future in which the importance of technology and innovation are certain only to grow.