If the lengthy rally in the U.S. information-technology sector comes to a halt, it will be challenging for the broader stock market to end the year with positive returns. However, it won’t be impossible, according to some analysts.
Much will depend on how well the health care, consumer discretionary, financials and industrials perform over the next several months.
While it’s too early to write the obituary of the U.S. technology sector yet, the swift and steady decline over the past few sessions has left many investors uneasy.
The tech-heavy Nasdaq Composite COMP, -1.39% which was trading at record levels just last week, is down about 4% from its peak.
Read: High-flying tech sector is vulnerable to deteriorating credit quality
The latest slump for tech comes after Facebook Inc.’s FB, -2.19% shares plunged following disappointing earnings. The stock is now officially in a bear market, having lost more than 20% of its value since last week.
Facebook is one of the so-called FAANG stocks — which also includes internet giants Amazon.com Inc. AMZN, -2.09% , Apple Inc AAPL, -0.56% , Netflix Inc NFLX, -5.70% and Google-parent Alphabet Inc. GOOG, -1.51% GOOGL, -1.82% — that collectively have been fuelling the tech sector’s gains over the past several years.
Also see: Why investors shouldn’t sweat the stock market’s reliance on FAANG shares
Because the tech sector comprises a quarter of the total market capitalization of the S&P 500 index SPX, -0.58% the broader market may find it difficult to advance if the industry turns decisively lower. The only way it may be able to avoid widespread pain is if health care, consumer discretionary, industrials and financials — which comprise half of the market — ignore the tech woes and continue to advance.
Is it possible? Yes, but some caveats apply, according to Nicholas Colas, co-founder of DataTrek Research.
The health-care sector is likely to benefit as a good growth substitute to tech, mainly because its earnings growth is not far from the pace seen in the tech sector, while valuations are lower. According to FactSet, the health-care sector is expected to see 9% earnings growth in 2019, compared with 11% for the tech sector. Meanwhile, 12-month forward valuations for the health-care sector are at 15.8, compared with 19 for tech. S&P 500 earnings are expected to grow by 10% in 2019, and its P/E stands at 16.7.
Investing in growth stocks—normally those whose profits grow faster than the average market —has been a winning strategy over the past several years. By contrast, value stocks —that are trading below their intrinsic value —underperformed over the same time.
Relying on the consumer-discretionary sector is riskier, however, as more than a third of the sector is comprised of Amazon.com and Netflix — stocks that are part of the aforementioned FAANG group. Besides, the sector is already up 12% year to date.
Financials, which have done well over the past month thanks to higher interest rates, could continue to advance if the trend of higher long-term bond yields continues.
Banks, which borrow in short-term markets and lend on a long-term basis, rely on steeper yield deferential for profits.
The fact that the benchmark 10-year yield is flirting with the 3% yield should, in theory, bode well for banks.
Another reason financials could continue to advance has to do with their much cheaper valuations. Investors could rotate into value stocks and out of growth if the tech sector experiences a prolonged decline.
Finally, industrials, which have already risen nearly 6% over the past month, have a shot for more returns, as long as trade tensions don’t flare up.
“The [industrial sector] could really use some good news on the trade front (possible, if only because the president likely wants some wins to campaign with ahead of midterm elections),” Colas said in a note.
