Can the Rest of the Market Rally If Tech is Weak?
The tech sector declined again last week and weighed on the S&P 500 as concerns continue to grow around all the AI-related spending commitments and the potential negative implications for tech stocks and the economy if that cap-ex spending slows. Nothing especially bad happened last week in the tech space. Yes, CoreWeave (CRWV) declined post earnings on a revenue miss but that was due to timing, not a lack of overall demand. Meanwhile, other tech companies (AMAT and CSCO) posted strong numbers, and in general the outlook for AI spending remains as robust as it was three weeks ago (when stocks were surging on the daily announcements).
Instead, the rising number of articles and opinions doubting the sustainability of the AI cap-ex boom is leading to a rise in skepticism that fed on itself last week, as selling created more selling in the tech sector. Now, investors are looking for NVDA earnings, out Wednesday after the close, to “stop the bleeding” and remind investors of the earnings growth and extreme cap-ex spend that is powering the entire AI boom. Essentially, investors expect strong NVDA earnings to quell the recent uptick in AI skepticism that is behind this decline in tech and the S&P 500.
But what if that doesn’t happen? What if NVDA results aren’t good enough to stop this modest increase in AI skepticism? In that case, can the rest of the market hold up while tech/AI decline?
History implies it’s not likely, but it is possible. Over the past three years, there have been three times the Nasdaq has declined by more than 10% over an extended trading period (which I define as a few weeks). Essentially, these have been the three pullbacks/corrections in the extremely strong tech bull market.
In two of those instances, July 2023-October 2023 and February of this year until April, the rest of the market did not hold up when tech fell. In both instances, the QQQs fell 10.5% and 23%, respectively, while the equalweight S&P 500 ETF (RSP) declined 13.2% and 16.4%.
Point being, diversifying away to the rest of the market didn’t really matter. However, there is one instance, early July 2024 until early August 2024, where the rest of the market did hold up. During that period, QQQ fell 12.5%, while RSP was essentially flat. In that instance, the declines in tech were driven by underwhelming Q2 earnings and broader concerns about economic growth (the labor market data got soft and inflation rose). That stagflation environment hit the most expensive/highest flyers the hardest, while more value-oriented sectors held up and offered significant outperformance.
Bottom line, if the concerns about tech are singularly focused on that sector (which so far, they are) and we get a mild stagflation impulse that pressures richly valued stocks, history does somewhat imply RSP can outperform. However, we will need to watch this closely to make sure we can weather any potential AI-related tech declines into year-end, whether that means allocating more to the rest of the market via RSP or just getting defensive altogether (by raising cash).
For now the earnings reports have been stellar for the third quarter and the temperature of the market is till warm to hot. We will continue to monitor any weakness but my guess is there is going to be a strong finish to the year.
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