While the earnings share of US technology companies in the S&P 500 index is decreasing, their weighting in market capitalization remains near multi-year highs. This divergence is raising concerns that sector valuations are deviating from fundamental profitability trends.
According to a Reuters analysis, the share of technology companies in the total earnings of the S&P 500 fell to 20.8% in the third quarter, below the 22.8% level three quarters earlier.
However, the market capitalization share of companies in the sector in the index increased from approximately 30% at the beginning of the year to 31.1%. Analysts warn that any disappointment in profitability could lead to sharp declines across the index due to the high weighting of the technology sector in passive fund portfolios. Illia Kyslytskyi, research director at Yaru Investments, stated that while some of the high valuation of technology stocks can be explained by the companies’ future profit potential and free cash flow growth, this does not fully account for it. Growth expectations focused on artificial intelligence are propelling technology stocks to new records, while also making their valuations more dependent on rapid profit growth. The Nasdaq Composite index is trading at a forward price-to-earnings ratio of 29.28, based on current year-to-date earnings estimates; this level is above both its 10-year average of 23.48 and the S&P 500’s ratio of 24.35.Although the sector reported high profits in the third quarter, particularly with strong performance from AI leaders like Nvidia, experts emphasize that future earnings will depend on the revenue growth that AI technologies provide to customers and how efficiently companies manage their spending.
Alexander Lis, investment director at Social Discover Ventures, stated that the “Magnificent Seven” tech giants are temporarily achieving high margins as their AI investments translate into early revenue for suppliers, and that profitability could normalize when spending slows. The Nasdaq index has risen 18.4% year-to-date, but has fallen over 3.5% this month. Derek Izuel, portfolio manager at Shelton Capital Management, said that if earnings fail to support valuations, tech stocks could experience a mid-single-digit pullback, but the decline could reach double digits if the risk premium returns to normal.
