Technology stocks are riding high following Nvidia Corp.’s latest blockbuster earnings report, which helped push the Nasdaq-100 and the S&P 500 technology sector to fresh record highs last week.
But after looking past the index-level performance, there are signs that the momentum that has propelled the sector higher over the past year is starting to fade.
Unprofitable technology companies have started to roll over. Popular momentum gauges show the pace at which the average tech stock has outperformed the average S&P 500 stock has slackened. And the share of tech stocks trading above their medium-term averages has declined from its recent highs, although it remains well above 50%.
Meanwhile, valuations for the average technology stock have returned to their peak from November 2021, according to JC O’Hara, chief market technician at Roth MKM.
See: more stocks are joining the market’s rally — even as Big Tech still gets the most attention
The average tech stocks’ relative momentum is starting to slow
While technology stocks remain firmly in an uptrend, their outperformance relative to the average S&P 500 SPX stock has started to slow.
This is evidenced by a gauge of the average technology stocks’ outperformance compared with the average S&P 500 stock over the past 65 days, depicted in the chart below.
Such a shift has portended periods of underperformance for tech stocks in the past, not only in 2022, but in 2020 as well.
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The share of technology stocks trading above their moving average is declining
Taken together, the S&P 500 technology sector is still trading well above its intermediate-term average. But more individual technology stocks have started to lag theirs.
By O’Hara’s count, roughly 70% of the tech sector’s 64 constituents are trading above their 50-day moving average as of Friday. By comparison, late last year, that number was 90%.
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Valuations are looking stretched
Investors are paying a heavy premium for the average technology stock, evidenced by the trailing 12-month price-to-earnings ratio.
The ratio recently hit 35 times, a level that preceded the market peak from late 2021.
A version of the S&P 500 technology sector that assigns an equal weighting to each constituent stock only just took out those highs after more than two years. And during the interim, the gauge experienced a drawdown of more than 30%, according to O’Hara.
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Options traders are getting greedy
Traders piled into bullish options ahead of Nvidia Corp.’s NVDA, +0.80% earnings report last week. This pushed the 10-day put-call ratio, which measures demand for bullish options compared with demand for bearish options, firmly into greed territory.
However, history shows that options demand tends to mean revert, according to O’Hara. As of Friday, there was still plenty of room for options traders to shift from one side of the boat to the other.
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Unprofitable technology stocks are fading fast
Even technology companies that haven’t posted steady profits saw their shares rocket higher as the broader market rallied furiously in November and December. Some analysts described it as a “dash for trash.”
But since the beginning of 2024, many of these companies that have struggled to post steady profits have seen their shares lurch lower. Case in point: The ARK Innovation ETF ARKK, seen as a proxy for unprofitable technology companies, is down 5.3% since the start of the year following a gain of more than 48% between Nov. 1 and Jan. 1, FactSet data show.
In the past, these companies have acted as a canary in the coal mine, O’Hara said.
“When market stresses start to develop, the unprofitable companies are normally sold first, as they are extremely far out on the risk curve and have the largest downside potential,” he added.
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To be clear, O’Hara isn’t recommending that his clients rush to dump their technology stocks.
“We are still very much overweight Technology in our sector rankings,” O’Hara said.
But a recent spike in inquiries from clients asking for investment ideas outside of the tech piqued his curiosity.
He now expects a modest pullback that could carry the sector back below its 50-day moving average. This would equate to a drop of more than 4% for the XLK, according to FactSet data. The ETF was recently trading at $ 206.35 a share on Monday.
With that in mind, investors might want to consider buying some downside protection for their portfolios, he said. The lopsided put-call ratio means investors can purchase portfolio insurance relatively cheaply.
The tech-heavy Nasdaq-100 NDX, which has the heaviest weighting toward the biggest megacap technology stocks like Nvidia Corp., hit its latest record close of the year on Thursday, while the Nasdaq Composite COMP came within a hair of its first record close since Nov. 19, 2021.
Meanwhile the S&P 500 and Dow Jones Industrial Average DJIA finished last week with their 13th and 14th record closing levels of the year, respectively.
All three of the main indexes — the S&P 500, Dow and Nasdaq Composite — were trading in the red early Monday afternoon.