Investors have made big bets on tech stocks. Why one strategist just downgraded the sector.

By Jules Rimmer

RBC swaps overweight in technology stocks for healthcare, citing concerns of a market pullback of up to 10%

Between them, information tech (39%) and communication services (9%) make up almost half the S&P 500, whereas health care has just a 9% weighting

Combining the information technology and communication services sectors, tech stocks comprise almost half of the S&P 500. So when a strategist downgrades the sector from overweight to market-weight and swaps the exposure to healthcare, investors should pay attention -because it doesn't happen very often.

It's a contrarian call: the latest global fund manager survey compiled by Bank of America found that investors said they were more overweight on tech than any other sector.

Lori Calvisana is global head of equity strategy at RBC Capital Markets

So why has Lori Calvasina, head of U.S. equity research at RBC Capital Markets, switched horses as the markets enter the fourth quarter? The switch is motivated by strong outperformance of tech stocks XLK since mid-July, which has led to a deterioration in the "valuation signal" Calvasina is picking up for the sector. Going back to the late 1980s, RBC finds that the sector is now "slightly above average" on both an absolute and relative median price-to-earnings ratio.

When RBC upgraded the sector back in July, the sector was reasonably valued, but that's not the case today, Calvasina argues. She also checked out the price-to-earnings ratio against the post-COVID era and still finds it "pricey." She points out that fund flows toward global developed market tech funds have weakened recently and that earnings upgrades for semiconductor stocks are decelerating.

Calvasina observes, however, that tech outside of the United States still looks appealing on performance, valuation and demand metrics.

Macro factors have also influenced RBC's thinking on the downgrade. The strategy team remains concerned about the possibility of a 5% to 10% pullback in the S&P 500 SPX and notes tech stocks tend to lag in pullbacks triggered by previous Fed hiking cycles. Moreover, RBC detects a slight shift in global investment flows away from the U.S. and toward Western Europe. When this trend has emerged in the past, U.S. growth stocks -usually this means tech - tend to underperform.

In recent years, the performance of the healthcare XLV sector has negatively correlated with tech, making it, therefore, a natural destination when dialling down exposure on the latter. RBC analysts find improving flows, a positive earnings revision trend and decent valuations all favoring healthcare. Perhaps more importantly at this juncture, analysis showed that if bond yields BX:TMUBMUSD10Y stayed around 5.5% for a concerted period then the impact on healthcare was relatively muted compared to other sectors.

The other strategy recommendation included in the report published Wednesday was a downgrade in materials XLB to marketweight, chiefly owing to a weaker earnings revisions profile even though it scores well on valuations and performance. Elsewhere RBC maintains an overweight on financials XLF, highlighting earnings revisions, and underweight utilities XLU, citing expensive valuations.

-Jules Rimmer

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