The Tech Sector Continued To Outperform Broader Indexes As Companies Get Ready To Release Q3 Earnings

The tech sector continued its upward march throughout the third quarter, with the S&P Technology Select Sector Index (IXT) rising 8.48% from the start of July until the end of September. As we head into third quarter earnings season, as of October 6 the IXT is up 22.66% for the year, compared to the S&P 500 Index’s (SPX) 13.03% increase.

Within the S&P 500 Index (SPX), the Information Technology sector is expected to report 8% year-over-year revenue growth for the third quarter, according to FactSet. Out of the seven industries in the sector, FactSet's research projects three of them to report double-digit revenue growth: Internet Software and Services, Semiconductor and Semiconductor Equipment, and IT Services are projected to grow revenues 22%, 13% and 11%, respectively.  

Turning to earnings, the sector is expected to report 8.5% year-over-year growth, the second highest out of all 11 sectors in the S&P 500, according to FactSet. The Semiconductor and Semiconductor Equipment industry is projected to report the highest year-over-year earnings growth at 29% and if its estimates are excluded, the earnings growth rate for the sector is likely to drop to 3.7%.

FIGURE 1: A STRONG YEAR FOR TECH. As of October 6, the S&P Technology Select Sector Index (IXT), charted above, was up 22.66% year-to-date, compared to a 13.03% increase in the S&P 500 Index (SPX), which is the purple line. At the same time, the PHLX Semiconductor Index (SOX) has outpaced both, increasing 30.72% since the start of the year (teal line). Chart source: thinkorswim^® by TD Ameritrade.  Data source: Standard & Poor’s. Not a recommendation. For illustrative purposes only. Past performance does not guarantee future results.

Semiconductor Stocks Leading the Tech Sector

The Semiconductor and Semiconductor Equipment industry has remained in the spotlight over the past several quarters as it has significantly outperformed other sectors and industries.  As of October 6, the PHLX Semiconductor Index (SOX) is up 30.72% and many stocks in the industry have seen their shares rise rapidly, with some doubling or more over the past year.

Growth in cloud computing and the Internet of Things, artificial intelligence, gaming, strong demand from automotive and industrial companies, cryptocurrency mining and the launches of increasingly complex smartphones and consumer electronics are some of the widely cited tailwinds that appear to have benefited the industry in recent quarters. While many analysts are still optimistic regarding the overall outlook for the industry, it might make sense to tread cautiously ahead of upcoming earnings if you don’t have a high tolerance for risk.

Are Valuations Too Optimistic?

In Morningstar’s Quarter-End Insights report on the tech sector, it cautioned that “we still believe that valuations across tech are painting overly rosy scenarios in new and emerging technologies around artificial intelligence” and that “semiconductor equipment makers are some of the most overvalued names within the tech sector.”

On the other hand, many analysts think the higher valuations are justified and have indicated that the sector overall should be able to continue to grow revenue and earnings due to tailwinds from various technological trends. That said, they still caution that there are certainly overvalued names in the space.

Product Launches Ahead of the Holidays

September and October are typically busy months for new product launches ahead of the holidays and this year was no exception. Since the beginning of September, Apple Inc AAPL, Amazon.com, Inc. AMZN, and Alphabet Inc GOOG GOOGL have all released new products.

In some of their past product launches, all three of the companies mentioned above have run into inventory issues. In some cases, the companies were able to react to demand and produce more products, and in others, the waitlists could last several weeks. When it comes to the holidays, a couple weeks of being out of a popular product can potentially mean a big difference for not only the manufacturers, but also retailers carrying them.

The National Retail Federation, or NRF, projects holiday sales for 2017 might climb 3.6% to 4% year-over-year, totaling between $678.8 billion and $682 billion. According to NRF’s 2016 holiday survey, 29.5% of the people they surveyed planned to purchase consumer electronics and computer-related accessories.

FIGURE 2: NEW TECH PRODUCTS Companies have been busy launching new products ahead of the holiday season. Apple (AAPL) is charted as the pink line, Alphabet (GOOG) as the teal line, and Amazon (AMZN) as the yellow line, and the accompanying boxes highlight when they recently announced or released products. Chart source: thinkorswim^® by TD Ameritrade.   Not a recommendation. For illustrative purposes only. Past performance does not guarantee future results.

Repatriation Tax Break

The initial framework for Republicans’ proposed changes to tax legislation was released in recent weeks, with plans to cut the corporate income tax rate from 35% to 20%, as well as a proposed repatriation tax break, although a specific rate has yet to be determined. Most analysts see the healthcare sector and tech sector potentially benefiting the most from the repatriation tax break due to the size of their overseas cash holdings.

At the end of 2016, non-financial companies in the U.S. had $1.84 trillion on their balance sheets, with the tech sector accounting for 47% of the total, according to Moody’s Investor Services. Moody’s estimates that $1.3 trillion of that is held overseas.

When a similar tax break was implemented in 2004 under the Bush administration, the IRS estimated 843 companies brought back roughly $312 billion under that break, and the top five companies that repatriated the most cash were either in the tech or healthcare sector.

Looking Ahead to Earnings

One of the first tech giants to report earnings is International Business Machines Corp. IBM, which releases its results before market open on Tuesday, October 17. The end of October and early November is when a bulk of the companies in the tech sector report. Microsoft Corporation MSFT, Alphabet, and Intel Corporation INTC report after market close on Thursday, October 26. Twitter Inc TWTR reports before open on Friday, October 27, Facebook Inc FB. releases results after market close on Wednesday, November 1, and Apple will open its books after market close on Thursday, November 2.