Analysis-AI stock wobble points to US market reliance on tech

By Lewis Krauskopf

NEW YORK (Reuters) -This week's wobble in shares connected to artificial intelligence is a stark reminder that the U.S. stock market is ever more reliant on the technology sector to drive it higher.

The S&P 500 and Nasdaq Composite on Tuesday suffered their biggest one-day drops in nearly a month, weighed down by a sharp tech decline. The indexes recovered somewhat on Wednesday, while the tech group extended losses slightly.

Fueled by a long period of strong performance, tech is by far the biggest sector in the S&P 500, accounting for a roughly 36% weight in the benchmark index - a higher level than during the dot-com bubble era 25 years ago, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.

Adding in megacap companies that are not classified as part of the technology sector - Google parent Alphabet, Amazon, Tesla and Facebook parent Meta Platforms - the combined weight amounts to nearly half of the S&P 500.

With so much riding on prospects for AI, the sector's heavy weighting in major indexes leaves broader markets vulnerable to negative developments, investors said.

"A significant percentage of the S&P is tied to one single sector and one single theme," said Walter Todd, chief investment officer at Greenwood Capital in South Carolina. "If there is some hiccup around (AI) ... anything like that is a risk to the individual names, but also the market overall."

The sector has declined over 3% since last week, with weakness in names such as Palantir Technologies and Nvidia that have been signature stocks in the AI trade.

Investors say tech shares might have been due for a breather after a strong run, and such a pullback can serve as a healthy reset that paves the way for further gains. At the same time, with much of Wall Street wary of signs of an "AI bubble" in the stock market, any weakness is being scrutinized as potentially the start of more severe declines.

The CEOs of Morgan Stanley and Goldman Sachs on Tuesday cautioned that equity markets could be heading toward a drawdown, underscoring concerns about elevated equity valuations. The S&P 500's forward price-to-earnings ratio is around 23 times, above its 10-year average of 18.8, according to LSEG Datastream. The tech sector's forward P/E ratio of about 32 times is also well above its 10-year average of 22.2.

Stellar tech performance has been a hallmark of the current bull market, which recently surpassed three years. While the S&P 500 has gained 90% during its bull run, the tech sector has gained 186% over that period.

Its recent decline notwithstanding, tech has also been the best-performing of the 11 S&P 500 sectors year-to-date, rising about 27% against an over-15% gain for the broader S&P 500, which remains not far from record highs.

That outperformance means tech's weighting in the S&P 500 has increased from just under 33% at the start of the year to its current level of about 36%. The next biggest sector, financials, has a weight of 13%. 

"If the tech stocks go down in any kind of sustained meaningful way, the indexes will go down," said Matt Maley, chief market strategist at Miller Tabak.

Strong tech profits have been supporting the stocks' gains and their heavy index weightings. Tech is expected to account for about 25% of aggregate S&P 500 earnings in the third quarter, according to Tajinder Dhillon, head of earnings research at LSEG.

Indeed, investors are quick to say that the tech companies at the heart of the AI theme are financially much stronger in general than many of those during the dawn of the internet 25 years ago.

"The companies that are leading the charge and making money off AI, these are real companies with real cash flows," said Scott Wren, senior global market strategist at Wells Fargo Investment Institute.

Wren said large tech companies' ability to maintain strong capital spending related to AI has been one of the key drivers of the stock market.

"If it's just even a whiff that that's not going to play out, markets are going to be immediately low on that," Wren said.

(Reporting by Lewis Krauskopf; Editing by Alden Bentley and Richard Chang)