The tech reset accelerates: Putting the downside in perspective

Key takeaways

• The tech love-hate relationship continues. After leading the market higher, technology (tech) has fallen 10% from its peak as investors scrutinize AI capital spending, free cash flow, and the durability of earnings growth.
• The weakness has been narrow rather than market-wide. Tech and communication services were the only sectors to advance in September and are now the only sectors down in October, reflecting a sharp rotation rather than broad liquidation.
• Additional downside is possible, but our stress test provides perspective. A combination of historical pullbacks, valuation, and technical support suggests potential downside of roughly 2% to 8% for tech from current levels.
• Valuation is becoming increasingly supportive. Tech now trades below consumer staples and industrials and roughly in line with health care, despite having the strongest earnings growth estimates for next year and the strongest near-term earnings momentum.
• Bottom line: The corrective process may not be complete, but the weight of the evidence suggests the longer-term tech uptrend remains intact.

In September, tech and communication services were the only sectors to advance, and early this month, tech was the only sector to reach a new high. But as October progressed, the picture flipped sharply: tech and communication services are now the only sectors in negative territory this month, amid a furious rotation into the other nine sectors.

We see the sharp decline in tech and rotation into prior laggards as driven by four main forces:

• First, tech’s strong outperformance set a high bar for earnings and guidance, while much of the broader market entered the month oversold.
•  Second, the pullback in the 10-year U.S. Treasury yield supported rate-sensitive, cyclical, and defensive sectors that had been beaten up as investors increasingly viewed tech as defensive growth last month.
• Third, AI and cloud demand remain strong, but investors are becoming more discerning. Weakness in parts of the mega-cap companies’ non-AI businesses, alongside growing capital spending requirements, has brought profitability, free cash flow, and the timing of AI monetization to the forefront.
• Fourth, concerns that companies may struggle to raise capital to sustain the AI buildout, reflected in rising borrowing costs and equity weakness.

The story is no longer simply about the strength of AI demand. Wall Street is increasingly demanding evidence that heavy investment will translate into durable profits and cash flow.

Tech and communication services have weakened, but capital has rotated toward areas that previously lagged rather than exiting equities altogether. This does not eliminate risk, but rotation is healthier than broad liquidation and can help strengthen the market’s foundation.

Still, the rotation has been swift. Health care and consumer staples have outperformed the S&P 500 by more than 10 percentage points over the past month, near the upper end of their relative performance ranges during this bull market.

This suggests some defensive areas may be becoming stretched to the upside on a short-term basis, just as tech is becoming stretched to the down

Since the bull market began in October 2022, the S&P 500 has gained approximately 111%, tech has advanced roughly 230%, and semiconductors have risen more than 380%.

Against that backdrop, tech’s current 10% decline does not appear abnormal relative to prior pullbacks during this bull market.

No single measure provides a precise market floor. However, valuation, historical pullbacks, and technical levels suggest potential downside of roughly 2% to 8% for the tech sector from current levels, with valuation providing the most compelling support.

When the current bull market began in October 2022, tech’s forward price-to-earnings ratio reached a low of 18.2x. Applying that multiple to current forward earnings estimates would imply a price level near 6,600, approximately 2% below current levels.

The key risk is earnings estimates. To date, however, there are limited signs of broad deterioration. Over the past three months, tech’s forward earnings estimates have risen approximately 17%, more than double the increase for the S&P 500.

The five prior tech pullbacks during this bull market ranged from 10% to 26%, with an average decline of 17%. A pullback consistent with an average decline suggests additional downside of 8%.

The June lows and the rising 200-day moving average provide another potential support zone approximately 5% to 7% below current levels.

Tech now trades at a lower forward valuation than consumer staples and industrials and roughly in line with health care, despite having the strongest estimated earnings growth for next year and the strongest near-term earnings momentum.

The discount reflects legitimate concerns about AI capital spending, free cash flow, and the timing of monetization. Still, relative valuations are becoming increasingly attractive, while the earnings evidence remains more constructive than the recent price action.

• Tech’s near-term momentum has weakened.
• Investors are demanding greater evidence of AI monetization.
• Capital markets (debt and equity) are becoming less supportive of the AI buildout.
• Cyclical and defensive sectors have benefited from a sharp rotation and lower U.S. Treasury yields.

• AI and cloud demand remain strong.
• Tech earnings revisions continue to outpace the broader market.
• The sector’s longer-term trend remains positive.
• Valuations have compressed materially and now compare more favorably with other sectors.
• Our structural overweight to tech and positive view of the growth style.

A sustained deterioration in forward earnings estimates, weakening AI and cloud demand, a breakdown below longer-term technical support, or a broader deterioration in credit and financial conditions would warrant reassessing the outlook.

Bottom line

The tech love-hate relationship continues, and the corrective process is likely not complete. Our stress test suggests additional potential downside of approximately 2% to 8%. At the same time, valuations are becoming more supportive, earnings momentum remains solid, and the defensive rotation is starting to look stretched.

We’ll keep an open mind. The situation remains fluid, with many crosscurrents, and history reminds us that prices often lead shifts in the fundamentals. Yet the weight of the evidence still favors this being a reset within the longer-term tech uptrend.

As always, we will continue to follow the weight of the evidence, keep an open mind, and update our views as conditions evolve.