The End Is Near For Tech Dominance In The Stock Market

Tech stocks have been dominant in the stock market for over a decade.

However, according to Savita Subramanian, Head of U.S. Equity & Quantitative Strategy at Bank of America Merrill Lynch, the strong outperformance in tech may begin to spread to other sectors of the stock market.

Is the seemingly perpetual tech dominance in the stock market finally coming to an end?

What Contributed to Tech Dominance and What Has Changed?

While low interest rates, excess liquidity, and weak economic growth have been commonly cited as the direct drivers of tech stocks since 2009, the real driver is earnings.

"Tech out-earned, thus Tech outperformed," Subramanian said.

But earnings growth differentials between tech and non-tech companies are finally beginning to narrow, which should gain the attention of investors.

"As earnings accelerate outside of Tech, investors will likely become more price-sensitive and seek out cheaper earnings growth," Subramanian explained.

Higher Interest Rates Make Long Duration Growth Stocks Like Tech Less Appealing

"Clearly earnings are the critical driver of outperformance, but higher rates could disproportionately hurt credit-sensitive, long duration growth stocks that still trade at lofty premia to higher cash returns, shorter duration counterparts," Subramanian explained.

Interest rates could continue to move higher or at least stay higher for longer than most expect due to waning demand for US 10-year Treasuries from the Federal Reserve and foreign buyers like China and Japan.

Meanwhile, higher nominal GDP growth puts upside pressure on real interest rates, and US sovereign risk, evidenced by record levels of debt to GDP, suggests a higher required return from Treasury bonds.

Current Economic Cycle Favors Cyclical Leadership

According to Bank of America's proprietary models, both the US and European economies are showing signs of entering the phase 1 "recovery" regime, which has historically favored value stocks over growth stocks.

"Information Technology and Communication Services have lagged in past Recovery regimes" with a 44% hit rate, Subramanian noted.

This trend suggests that the current economic cycle may favor sectors that are more sensitive to economic recovery, traditionally value-oriented sectors.

The Impact of AI and the Future of Tech Stocks

While technology stocks have been at the heart of the artificial intelligence-induced stock market rally, this could change as the adoption of AI hits saturated levels.

Shares of Nvidia and hyperscalers like Microsoft, Amazon, Alphabet, and Meta Platforms have surged due to heavy investments in AI-enabled GPU chips.

However, these gains might be temporary, and the lasting benefits could accrue to companies outside of the tech sector that see long-term margin improvements from integrating AI into their businesses.

"Capex takers within Tech could be transient beneficiaries," Subramanian said, adding that a similar dynamic played out with Rockwell Automation during the COVID-19 pandemic.

"COVID started a three-year ramp in automation spend, after which ROK became a core holding of active long-only funds, hitting 20% overweight.

ROK is now 60% underweight in the average fund, but capex spenders that grew labor-light have re-rated. Service sectors may be next in the AI disruption train," Subramanian explained.

The era of tech dominance in the stock market may be drawing to a close.

As earnings growth differentials narrow and higher interest rates make long-duration growth stocks less appealing, other sectors are poised to outperform.

The current economic recovery phase historically favors value stocks, and while AI has driven recent tech stock rallies, the next wave of gains could come from companies outside the tech sector that effectively integrate AI.

Investors should be prepared for a more balanced market where tech no longer reigns supreme.