The AI boom continues to support YTD Technology sector gains, but with a significant divergence at the industry group level. S&P 1500 Semis are +61.8% YTD equally weighted, supported by the massive amounts of AI infrastructure capex. Software is down -17.2% on concerns about business models and future profitability. That leaves the question of whether the divergence will be converged or continue to widen. The quick answer is Software as a group is not poised to rebound.
YTD return breakdowns show the Software contraction is driven entirely by PE contraction. Nearby sales and margin estimates have been stable. Semis and Hardware have seen strong upward revisions to fundamentals, helping support their gains. Like Software, Semis has seen PE contraction YTD. Based on our fair value model, even after its 14% YTD decline, Software is roughly fair valued now.
Sentiment signals confirm the deterioration in Software. Earnings sentiment expressed by management of Software names deteriorated during 1Q reporting and internal sentiment related to company operations fell sharply. For contrast, internal sentiment for Semis and Hardware are neat all-time highs. External sentiment improved a bit for Software but remains well below that of Hardware and Software names.
The factor exposure for Semis and Hardware have diverged from Software as well. Semis and Hardware are more Momentum and Risk-on tilted, both factors that have outperformed this year. The risk for a Semis contraction also lies in a Momentum crashes if there is a shock to AI sentiment, or the Fed turns more hawkish or tightens financial conditions.
In aggregate, factor, fundamental, and sentiment readings suggest little room for a broad Software rebound. Software names that have better earnings revision and earnings sentiment should have better outlook than the overall industry group, and we list S&P 1500 Software names that meet the criterial at the end of the report.
Industry Group Divergence within Technology: The AI boom continues to support YTD Technology sector gains, but with a significant divergence at the industry group level. S&P 1500 Semis are +61.8% YTD equally weighted, supported by the massive amounts of AI infrastructure capex. Software is down -17.2% on concerns about business models and future profitability. That leaves the question of whether the divergence will be converged or continue to widen.
Breaking down the industry group return YTD, Software contraction has been more driven by PE compression than declines in sales and margin estimates. Alleviating Business model concerns remains the primary path to higher Software PEs. For Semis and Hardware, their gains can be better explained by fundamentals, especially for Semis. Gains by Semis and Hardware are easier to defend. However, given the fundamental divergence, it is hard for Software to catch up with Semis and Hardware.
Beyond standard fundamentals, sentiment expressed by Software managers about internal operations has deteriorated, diverging from readings within Semis and Hardware. Internal sentiment within Software has dropped sharply during 1Q reporting, making it the only group to post a meaningful negative move. That management sentiment toward earnings is deteriorating suggests the threat to Software profitability is real and will lead to negative Sales/Margin estimate revisions.
External sentiment – a measure of macro influences rather than company specific trends – is signally some improvement. External sentiment of Software names has stabilized though the level remains below that of Hardware and Software. At the margin, that is a support for Software multiples.
Current factor exposure is also diverging within Tech, contributing to industry group return differences. Semis and Hardware have positive Momentum and Risk-on exposures while Software is negatively exposed to both factors. Momentum and Riks-on have been strong performers this year, exacerbating the divergence of Semis and Hardware relative to Software. The immediate risk to Semis lies in a Momentum pullback after its surge over the past few months. That catalyst contenders for such a pullback are AI sentiment weakening, the Fed turning more hawkish, or Financials conditions tightening.
Previously, we published a fair value model (HERE) for Software based on Professor Damodaran’s discounted cash return method. Based on the methodology, the current S&P 500 Software Index is roughly around its implied fair value, even after its selloff.
Under current ERP for Semis, the implied fair value suggests -0.9% lower after yesterday’s 3.4% growth.
Hardware implied fair value is slightly higher, indicating about 4% upside.
For those looking for Software names that could buck the current downtrend in the space, there are still Software names with relative better earnings expectation and strong sentiment. They are likely to perform better than the index even if PE contraction continues. Below we list these S&P 1500 Software names that have more than 5% YTD NTM EPS revision and also positive Earnings Sentiment readings.
