How to protect yourself against a major tech correction
David Prosser explains why now might be the time to take some profits from tech stocks and reinvest them into less highly valued sectors.
23rd September 2024 09:56
by David Prosser from interactive investor
Investors can be fickle. NVIDIA Corp (NASDAQ:NVDA), the US technology company widely seen as a play on the artificial intelligence (AI) boom, revealed in August that it was on target to bank third-quarter revenues of $32.5 billion, ahead of analysts’ forecasts of $31.8 billion. Yet its shares immediately fell 7% amid perceptions that the company’s upbeat forecasts for the fourth quarter and beyond weren’t quite upbeat enough. Is it time to beat a retreat from the technology sector?
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Certainly, the sell-off at Nvidia prompted jitters throughout the sector; companies including Amazon.com Inc (NASDAQ:AMZN), Advanced Micro Devices Inc (NASDAQ:AMD), Broadcom Inc (NASDAQ:AVGO) and Microsoft Corp (NASDAQ:MSFT) all saw investors dump their shares in the subsequent days. Nothing material changed at any of these businesses. Investors simply began to question whether, after a long period of stellar performance, the technology sector was starting to run out of steam.
It is a reminder that sentiment matters in investment. No one questions the long-term potential of the technology sector or disputes the huge demand for AI tools and the companies behind them. And these companies are delivering. The so-called “Magnificent Seven” – Amazon, Apple Inc (NASDAQ:AAPL), Alphabet Inc Class A (NASDAQ:GOOGL), Meta Platforms Inc Class A (NASDAQ:META), Microsoft, Nvidia and Tesla Inc (NASDAQ:TSLA) – have increased earnings by nearly 1,200% over the past eight years, averaging 36% a year. In addition, their shares have averaged annual gains of 40%.
Tech giants command premium prices
But investors eventually grow anxious about whether such momentum can be maintained. And with shares in these companies trading on close to 35 times’ future earnings, twice the valuation of the rest of the stock market, any slowdown could be costly.
“Technology earnings results have been constructive for most companies,” says Mike Seidenberg, manager of Allianz Technology Trust Ord (LSE:ATT). “But we have seen several cross-currents arise of late, including growing investor concerns about the timing of the benefits from some emerging secular themes, namely AI, as enthusiasm may have eclipsed near-term fundamental factors.”
Managers in the sector don’t expect a “tech wreck”; in fact, many remain bullish. At Polar Capital Technology Ord (LSE:PCT) Trust, for example, manager Ben Rogoff recently explained: “We believe AI represents a rare example of discontinuous technology change, the impact of which we think is still being underestimated by many, and as such, we believe we are in the early stages of a major new cycle.”
Rebalancing helps to reduce risk
Nevertheless, many commentators believe now might be the moment for investors to consider their options. The inexorable rise of technology stocks in recent times means that the proportion of your portfolio exposed to the sector will naturally have increased. So, it might be sensible to reset by banking some of those profits and moving the money into other less highly valued sectors.
That holds true whether you’ve invested specifically in technology funds or are exposed to the sector through more generalist funds.
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Ben Yearsley, a director of investment adviser Fairview Investing, cautions: “Anyone in a global index tracking fund or a US tracker will have a reasonable technology weight, so even if you think you’re immune to a sell-off you probably aren’t.
“There’s nothing wrong with taking a profit and adding diversification to your portfolio is a good idea.”
Scott Gallacher, a chartered financial planner and director at independent financial adviser Rowley Turton, takes a similar view. “It’s fair to say that technology stocks have defied gravity for some time, and what goes up often comes down,” he warns.
Where to put tech profits to work
How, then, to reinvest any profits realised from technology holdings to mitigate risk?
One option is to make a concerted move into defensive assets. “Consider assets such as cash, bonds, lower- or medium-risk multi-asset funds, or wealth preservation trusts such as Personal Assets Ord (LSE:PNL), Capital Gearing Ord (LSE:CGT), and the Royal London Diversified ABS Fund,” Gallacher suggests.
Of those, Gallacher is a particular fan of the Royal London fund, which invests in asset-backed securities and fixed-income holdings.
“Another approach is to use what could be low or even negatively correlated assets – particularly UK equities, which seem undervalued but require careful selection to avoid value traps,” Gallacher adds.
He continues: “A good example is Invesco UK Equity High Income Fund, which famously avoided technology stocks during the 2000 dot-com crash; similar investment trusts include Murray Income Trust Ord (LSE:MUT), which focuses on generating income through value-oriented UK equities.”
Look to cheaper regions
The geographical point is well-made. While the US stock market, as measured by the Nasdaq index, currently trades on a forward price-to-earnings ratio of more than 40 times’ the equivalent figure for the FTSE All-Share index is below 15. While UK equities have performed strongly during 2024, many areas of the market remain on lowly valuations compared to their international peers.
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Ben Yearsley also has several suggestions. “Polar Capital Global Insurance buys specialist insurance companies and has delivered an excellent long-term return with less earnings volatility,” he says. In the wealth preservation field, his pick of the bunch is Personal Assets, managed by Sebastian Lyon of Troy Asset Management, which invests in high-quality companies, as well as gold and index-linked government bonds.
Alternatively, for investors looking to retain stock market exposure, Yearsley argues for a move away from “growth” stocks, valued according to their future prospects, in favour of a “value” approach, which looks at what companies are worth today
“You want a style difference,” he explains. “Take a look at RGI Global Recovery managed by Hugh Sergeant.” This fund, as well as the UK version, RGI UK Recovery, focuses on companies that are priced attractively, often because they have been out of favour for a period.
Passive picks
Fans of passive fund management still have options, adds Dzmitry Lipski, interactive investor’s head of funds research. He suggests the iShares Edge S&P 500 Minimum Volatility ETF (LSE:SPMV) is a good option.
“It tracks the performance of an index composed of selected companies from the wider S&P 500 index, which collectively exhibit lower volatility than the broad market, while maintaining characteristics such as sector and factor exposure that are similar to the S&P 500,” says Lipski.
Alternatively, the Invesco S&P 500 Equal Weight ETF Acc (LSE:SPEQ) provides equal exposure to every stock in the S&P 500. The idea is that you’re not avoiding any stocks altogether, but you’re also not a hostage to fortunes. Every individual share will generate 0.2% of the returns achieved by the ETF as a whole, with the vehicle constantly adjusted to make sure this remains the case.
Away from passives, Lipski’s pick is another defensive option.
He explains: “Capital Gearing Trust has two objectives: to preserve capital over any 12-month period and to deliver returns well in excess of inflation over the longer term.
“It aims to achieve its investment objectives through a long-only, multi-asset portfolio of bonds, equities and property, with small holdings in infrastructure, gold, and cash.”
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At the same time, Lipski is keen to remind investors that trying to call market – or sector – ups and downs often proves fraught with difficulty. He points out: “Going forward the market may see more uncertainty and volatility, but remember the old wisdom that the best investment outcome is achieved through time in the market, not timing the market.”
In other words, don’t throw the baby out with the bathwater. Top-slicing your technology holdings with a view to rebalancing your portfolio is not the same as dumping all your exposure to the sector.
To do so would be to miss out on future exciting growth opportunities argue advocates for the sector such as Richard Clode, a portfolio manager on the Global Technology Leaders Team at asset manager Janus Henderson.
Clode says: “The recent sell-off in tech stocks was unsurprising given the strong first half, but the ferocity of the moves was exacerbated by the rapid pricing in of a US recession and a huge amount of leverage that investors took on to access AI opportunities.
“The fundamentals of many technology companies remain strong – and market volatility provides opportunities for active managers to take advantage of price dislocations.”
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