A bear market typically uses brutal force to smash stock prices, making them cheaper. However, the tech sector has discovered an alternative path. At its low point in July this year, the forward price-to-earnings ratio (the price investors pay for expected earnings) for the tech sector dropped by about 30% compared to a year earlier, a decline similar to what was seen during the dot-com bubble burst and the financial crisis. Yet, the S&P 500 Index is now hovering near all-time highs, making this situation even more peculiar.
The Technology Select Sector SPDR Fund has staged a powerful rally from its March 30 low. When measured by a 45-day rate of change, this is the strongest surge in the history of XLK since records began in 1999. For the Philadelphia Semiconductor Index, with data going back to 1994, only the March 2000 surge was stronger than this one. So, how can stocks both soar and become cheaper at the same time?
Consider a stock priced at $100 with expected earnings of $5 per share. Investors are paying $20 for every $1 of expected profit, so its forward P/E is 20 times. If the stock rises 40% to $140, it sounds more expensive. But imagine its expected earnings skyrocket by 80% to $9. In this case, investors are paying only about $16 for every $1 of expected profit. The stock price increased, but it became cheaper.
This phenomenon is playing out across the entire tech sector. Over the past year, tech stock prices have risen by about 40%, while expected earnings have surged by approximately 80%. Earnings growth has outpaced stock price gains. A bear market typically achieves this through painful means: stock prices crash, an economic recession slashes profit expectations, and optimism is driven out of investors' minds. When the dust settles, buyers can often acquire surviving profits at much lower prices. This helps explain why some of the strongest rallies often begin when economic headlines still look terrible. The stock market starts anticipating recovery before the economy itself recovers.
This time, the tech sector has reaped most of the benefits without dragging the entire market into a demolition site. But there is an obvious way this situation could unravel. Lower P/E ratios can only be sustained if those expected profits are actually realized. Large tech companies are pouring massive amounts of capital into chips, data centers, networks, and electricity. Investors are already questioning who will profit from this AI spending spree and who will be forced to foot the bill. If AI capacity builds out too quickly, clients slow their spending, chip pricing weakens, or the economy hits corporate tech budgets, analysts may begin to cut these future profit expectations.
At that point, the trick will reverse. Take the same stock priced at $140 with expected earnings of $9, giving it a P/E of about 16 times. If expected earnings are cut to $6, the stock's P/E suddenly jumps to more than 23 times, even though the stock price hasn't moved at all. The stock itself hasn't changed, but it has suddenly become much more expensive. Now, the bullish argument boils down to one thing: the profits must materialize.
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