IYW: Beware of significant correction due to high valuation

Introduction

We last covered the iShares US Technology ETF (NYSEARCA: IYW) in March 2023. At that time, we recommended investors to accumulate shares of IYW as we see good long-term opportunities, especially after the significant correction in 2022. Since that article was published, IYW has delivered a total return north of 70%. Now that it’s been about 1.5 years since we last covered this fund, it’s time to take another look at IYW and offer our thoughts and recommendations again.

Overview of ETFs

IYW invests in a portfolio of approximately 140 mostly large-cap US technology stocks. The fund has a high expense ratio of 0.39%. For example, The Technology Select Sector SPDR ETF (XLK) charges just a 0.09% expense ratio. IYW should benefit from many secular technological growth trends. The price of its shares has risen significantly since hitting a cyclical low in October 2022. Market AI hype was one of the main reasons for this outperformance. However, its valuation is expensive now. Any weakening of demand for AI could cause its share price to drop significantly. Therefore, we believe investors may want to look for a larger margin of safety and wait for a better entry point.

Background analysis

IYW has done very well since the cyclical low of 2022

Let’s take a quick look at IYW’s performance over the past few years. After a significant correction in the first ten months of 2022, IYW’s fortunes turned positive. Since the October 2022 cyclical low, IYW has seen its share price increase by 106.6%. Including dividends, IYW delivered a total return of 108.2%. This performance was much better than the S&P 500’s price return of 57.6% and total return of 62.4%. Over the past 10 years, IYW has also outperformed the S&P 500, posting a total return of 526.0%, much better than the S&P 500’s 238.8%.

AI overkill is one of the main causes of IYW performance

As we pointed out in our previous article, stocks in the IYW portfolio will continue to benefit from many secular growth trends such as automotive electrification, artificial intelligence, industrial automation, Internet of Things, cloud computing, etc. the early 2023 performance was AI hype. To deliver AI models and services, many software and cloud service providers need next-generation semiconductor chips, and semiconductor designers and manufacturers are benefiting from increased demand for these chips. For example, AI chip designer Nvidia (NVDA), which comprises about 13.7% of IYW’s portfolio, has seen its share price rise nearly 1,000% since October 2022. That’s nearly 10 times IYW’s performance over the same period .

Other semiconductor stocks have seen their stock prices rise significantly, though not on the same scale of performance as Nvidia. This is evident in the fact that in March 2023, when we wrote our previous article, the semiconductor and equipment sub-sector represents only about 24.4% of IYW’s total portfolio. Over the past 1.5 years, this subsector now represents 31.4% of IYW’s total portfolio (see chart below). The market seems to be very optimistic that AI will lead to a significant transformation of many industries.

Valuation is still expensive despite recent corrections

Let’s check the IYW rating now. Below is a chart showing the forward P/E ratio of information technology stocks in the S&P 500. Since there is significant overlap between the IYW portfolio and the information technology stocks in the S&P 500, the chart will help us gauge the change in valuation technology sector in the past. In other words, the exact number is not that important. It is its current valuation relative to the historical valuation we are comparing. As can be seen from the chart, the current forward P/E ratio of 28.6x is still higher than the peak reached during the pandemic even after the recent correction in July. In fact, as the chart suggests, we haven’t seen a valuation this high since the burst of the Internet-dot-com bubble. Therefore, we believe that IYW is now quite expensive.

Source: Yardeni research

The downside risk can be very high

As shown in the previous chart, the valuation range of the technology sector can be very wide. In the significant market correction of 2022, the technology sector’s forward P/E has fallen significantly from a peak of nearly 30x to below 20x. As shown in the chart below, a combination of multiple compression and negative earnings growth has caused IYW to decline nearly 40% in 2022. This decline is much more significant than the S&P 500. This higher volatility is also evident in that IYW has a much higher beta of 1.28 than the S&P 500. As the chart below shows, IYW has typically fallen much more than the S&P 500 in previous corrections, such as in 2016, 2019 and 2022. The drop in 2020 is an exception, as the technology sector is one of the only sectors to benefit during COVID-19. 19.

Watch out for AI server demand drop

As I stated earlier, one of the main drivers of the strong performance of many tech stocks over the past year is due to AI hype. Currently, many cloud service providers (CSPs) such as Alphabet ( GOOGL ), Microsoft ( MSFT ), and Amazon ( AMZN ) continue to allocate a large portion of their capital expenditures to the purchase of AI servers. At this point, there may be more demand than supply. However, things could reverse just as they did towards the end of the pandemic. Could there be overbooking now? It’s hard to say. What if these CSPs realize they don’t need that many servers? Remember that we faced similar issues towards the end of COVID-19 as demand for many technology products declined rapidly. Therefore, if demand for AI servers declines, many semiconductor stocks may underperform. In such a scenario, the market’s optimism towards tech stocks can also quickly wane. If this happens, we believe that the price of the IYW fund will likely experience a significant decline.

Investor Takeaway

While we like IYW’s strong long-term growth prospects, we think the tech sector is now expensive based on our valuation analysis. Therefore, we believe investors should be cautious and patiently wait for a better entry point.

Additional Disclosure: This is not financial advice and that all financial investments involve risks. Investors are expected to seek professional financial advice before making any investment.