Megacap tech stocks out of control? Big Tech still has the power to extend the rally and weather an economic storm, analysts say.

Meanwhile, the Nasdaq Composite
COMP,
-0.24%
gained over 3% on a weekly basis. The tech-heavy gauge has risen 20.9% so far in 2023, according to FactSet Data. That compares with a 9.2% year-over-year gain for the broader S&P 500 index
SPX,
-0.14%
and a merely 0.8% increase for the Dow Jones Industrial Average
DJIA,
-0.33%.
 

Shares of America’s tech behemoths have been buoyant so far in 2023. Apple Inc.
AAPL,
+0.06%
stocks have risen nearly 35% this year, putting its market capitalization surpassing that of the entire Russell 2000
RUT,
-0.62%
for two weeks, the longest stretch on record, according to Bloomberg data shared with MarketWatch. Meta Platforms Inc.
META,
-0.49%
has jumped 104.1% year-to-date and Google’s parent, Alphabet Inc.,
GOOGL,
-0.06%
has advanced 39.1% over the same period, according to FactSet Data.

See: A stock-market milestone: Apple is now worth more than the entire Russell 2000

MarketWatch spoke with analysts to explore what factors have resulted in technology stocks being the dominant force in the U.S. equity market in 2023, and what drawbacks they could have this year.

A reversion of the 2022 trades

First, investors were very cautious with low expectations for the tech sector coming into 2023 after the bear market of 2022, which is “a good starting point for a group to outperform when there are skeptics that give you a chance to prove them wrong,” said John Porter, chief investment officer and head of equity at Newton Investment Management. 

The Nasdaq Composite slumped nearly 33% in 2022 as the high-growth nature of stocks in the tech-heavy index left them particularly vulnerable to the rise in interest rates engineered by the Federal Reserve to combat inflation.

“They’re considered growth stocks, and people are willing to pay a higher valuation as they’re expected to grow,” said Mike Dickson, head of research and product development at Horizon Investments. “Looking backwards on a year-over-year basis, they actually haven’t been growing, but from an expectation standpoint, it does appear that right now is probably the trough for earnings unless we get very bad growth prospects going forward.” 

Strong balance sheet and durable revenue streams

Megacap results in this past quarterly earnings reporting season seem to be taken as confirmation that the sector can continue delivering strong growth, given their rock-solid balance sheets, strong cash-flow generation and robust profit margins. 

“They are large companies with well-diversified revenue bases, with no debt, with profitable income statements, with strong balance sheets,” said Olivier d’Assier, head of APAC applied research at Qontigo, in a phone interview on Friday. “Even though they [investors] are betting on tech, they’re betting on the conservative of the safe segment of tech. They [megatech] can weather the storm.”

Porter said he has seen a new wave of “cost discipline” in some high-profile tech companies. Their control of costs is translated into faster-than-expected earnings improvement, making their balance sheets and revenue streams more appealing to investors compared with other types of stocks, said Porter.

Among 95% of S&P 500 companies which reported results in the first quarter of 2023, 78% of them have reported a positive earnings-per-share surprise, which is above the 5-year average of 77%, said John Butters, senior earnings analyst at FactSet. 

A potential end to Fed rate hikes

Signs that U.S. inflation is starting to moderate and the Federal Reserve is nearing the end of its interest rate hiking cycle also contributed to the tech leadership, said market analysts. 

Fed Chair Jerome Powell on Friday said his colleagues think that it will take some time to bring inflation back to the central bank’s 2% target, while confirming that the Fed has not yet decided what to do at its June 13-14 FOMC meeting. Dallas Fed President Lorie Logan said Thursday that the data points so far don’t justify skipping a rate hike in June.

Fed-funds futures traders Friday saw a 16.8% chance of another quarter-of-a-percentage-point rate hike by the central bank in June, according to CME FedWatch tool. 

Big Tech’s AI craze

Still, the most significant driver of megacap tech’s outperformance over the last six or eight weeks has been artificial intelligence (AI), Porter told MarketWatch in a phone interview on Friday. 

“We’re in a hype cycle here around AI, which has created a halo around a lot of key stocks in the tech sector, and that’s been sort of the icing on the cake,” Porter said. 

For example, investors have flocked into Nvidia Corp.
NVDA,
-1.31%
this year, putting the chip maker’s stock up 113.9% so far in 2023. Jensen Huang, Nvidia’s founder and chief executive predicted revenue from artificial-intelligence platforms will grow significantly in the next 12 months as businesses either climb on board with AI or get left behind. 

Meanwhile, Microsoft Corp.
MSFT,
-0.06%
has seen its stock surge by 32.7% this year and AI provider C3.ai
AI,
-5.74%
has exploded 125.9% over the same period, according to FactSet Data.

There is a pretty high probability that investors are going to see a “significant boom of AI profits and growth,” said David Russell, vice president of market intelligence at TradeStation. “We have new business, new products, which means higher margins and better pricing. We’re entering where the market is moving away from cloud-computing, cloud migration, and e-commerce … it [AI] is a game changer.”

See: AI is a ‘baby bubble’…for now, but a Fed ‘mistake’ could pop it, says Bank of America

Is megacap tech overvalued?

However, Michael Landsberg, chief investment officer at Landsberg Bennett Private Wealth Management, said tech stocks are “extremely overvalued” as even a company like Microsoft, was trading at price-to-earnings ratio of 33 in late April, which “seems a little pricey to us for a company that isn’t even growing its earnings by one third of its multiple,” he wrote in emailed comments. 

“We don’t mind paying for growth but overpaying for small growth doesn’t excite us,” he said. 

Big tech remains a large weighting in the S&P 500 index with Apple, Microsoft, Amazon.com
AMZN,
-1.61%,
NVIDIA, and Alphabet now making up more than 20% of the large-cap index. The current aggregate weight represents a notable increase from the 17% at the start of the year and is slowly beginning to approach the record level of 22.3% set in 2020, said BMO Capital Market’s strategists led by Brian G. Belski, chief investment strategist.

“As a result, many investors have become increasingly worried about the potential effects that this top-heavy concentration could have on market performance, especially if these names begin to stumble,” Belski wrote in a Thursday note. 

However, Belski and his team admit this concentration is not necessarily detrimental for performance. The chart below shows that performance breadth tends to increase in the six and 12 months after peaks in market cap concentration, as highlighted by the uptick in the percentage of outperforming stocks and uptrends in relative price of the S&P 500 Equal-Weighted index
SP500EW,
-0.28%.
 

Performance breadth usually indicates the number of stocks advancing relative to those that are declining in a certain stock index. An increasing market breadth occurs when more stocks are rising than are declining. 

See: The S&P 500 is top-heavy with tech. Here’s what that says about future stock-market returns.

To be sure, the persistent megacap tech rally doesn’t suggest a pullback is not possible in the near future as their biggest strength could be their biggest drawbacks, warned market analysts. 

“The biggest short-term risk is probably more macro than micro per se,” said Porter of Newton Investment Management, referring to the debt-ceiling negotiations in Congress and uncertainties around the Fed’s aggressive monetary tightening cycle. 

“Let’s dream for a moment that cooler heads prevail and Washington realizes that they need to set their own individual agendas aside regardless of your politics and do the right thing for the country. That [debt-ceiling deal] hopefully will happen, but if it doesn’t, that’s a source of volatility,” said Porter. 

“We probably need to continue to see the trends and economic data and get this debt ceiling resolved in the near future…. And if we get some of that out of the way, I think the rest of the market can participate [in the rally],” Dickson at Horizon Investments told MarketWatch via phone.

U.S. stocks finished the week modestly higher with the Dow industrials gaining 0.4% and the S&P 500 up 1.7%.