The tech rout is far from over.
That’s the warning from strategists this week as investors dump big tech stocks in favor of previously unloved areas of the market. The Nasdaq 100 closed the week down 2.7%, marking the third week in a row of declines, with the technology sector suffering its largest single-day percentage drop since October 2022.
The culprits: bets on Fed rate cuts, Tesla’s (TSLA) lackluster earnings, and fears about Alphabet’s (GOOG, GOOGL) AI spending ramp.
“Valuations were priced to perfection from an earnings standpoint and from an interest rate standpoint, that eventually we would see some sort of a valuation correction,” Verdence Capital Advisors chief investment officer Megan Horneman told me.
Horneman, who warned the AI trade is “hitting a wall,” added that this week’s rotation out of big tech is only the start of a “valuation correction.”
The significant shift under way has pushed small caps to the top of investors' buying lists. The Russell 2000 (RUT) recorded weekly gains for the third week in a row, marking its best three week stretch since 2022. Data compiled by Bespoke found that the outperformance spread between the Russell 2000 and the Nasdaq 100 (NDX) over the last 12 trading days, in favor of the small-cap index, is the second most extreme in the history of the two indices.
“With multiples as high as they are for the Mag seven, they're building in earnings growth. And if you don't see that earnings growth, that means that valuations come into question,” Commonwealth Financial Network’s Brad McMillan explained to me.
“There’s a threat of more pressure ahead,” McMillan said.
And that risk of slower profit growth, coupled with increased spending on AI, could signal that the “epic momentum reversal” will persist, unless big tech raises forward revenue guidance, according to Goldman Sachs.
In a note to clients, Goldman Sachs’ David Kostin wrote investors are starting to worry about the prospect of “overinvestment” in AI without timely proven returns, noting that Amazon (AMZN), Meta (META), Microsoft (MSFT), and Alphabet are driving the bulk of the spending.
“Consensus estimates of 2024 and 2025 capex and R&D spending by the hyperscalers have increased by $65 billion compared with expectations at the start of the year. However, analysts have lifted their sales forecasts for 2025 and 2026 by only $36 billion — a gap of nearly $30 billion,” Kostin wrote.
“These firms during the past six months have dramatically increased their planned spending on AI initiatives but it is not apparent when the return will come — in 2027, 2028, 2029, or perhaps not at all,” he added.
As our markets reporter Josh Schafer noted, two charts in Yahoo Finance’s Chartbook suggest further selling ahead. Analysis by Truist’s Keith Lerner found that the S&P 500 sees an average correction of about 9% in the second half of the year, after the index rallies more than 10% in the first six months.
Meanwhile, BMO Capital Markets chief investment officer Brian Belski’s review of past performance found that stocks usually drop an average of 9.4% in the second year of a cyclical bull market, which started in October 2022.
“This market has become quite frothy with everybody looking to big cap tech stocks and chasing the market,” Belski told me. “It's really difficult to be overweight Apple or overweight Nvidia … especially given how much they've rallied.”
Safe to say, earnings results this coming week from Meta, Amazon, Apple, and Microsoft will be a crucial measuring stick. Any sort of disappointment, similar to what we saw from Alphabet and Tesla this week, could trigger more carnage for the tech market.
Seana Smith is an anchor at Yahoo Finance. Follow Smith on Twitter @SeanaNSmith. Tips on deals, mergers, activist situations, or anything else? Email seanasmith@yahooinc.com.
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