MSFT Microsoft Corporation

By Akane Otani and Michael Wursthorn 

The Nasdaq Composite Index overcame an early slump in the second quarter and is on course to book its eighth straight quarter of gains, as fears of a trade war stifling global growth pushed investors to dump industrial stalwarts and increase their bets on shares of large technology companies.

The tech-heavy index thrived in a tumultuous three months for U.S. stocks, which struggled to gain ground as investors were buffeted by worries about trade tensions, political uncertainty in the eurozone and signs of slowing momentum in the global economy.

The S&P 500 and the Dow Jones Industrial Average rose 2.9% and 0.5%, respectively, for the quarter through Thursday, trailing the Nasdaq's 6.2% advance. The first two remain well below their January records, while the Nasdaq notched a series of all-time highs in June.

The one-directional nature of the stock rally has left investors increasingly worried that a market whose gains have been heavily dependent on technology stocks could reverse sharply in the second half of the year.

"A lot of the investing public is piling into the same things," said Jim Paulsen, chief market strategist at Leuthold Group, who added that the S&P 500 would be mostly flat this year without technology companies. "There's a lot of sheep following one another."

Investors remained steadfast in holding the shares of technology-driven companies over much of the second quarter. That reflects bets firms such as Amazon.com Inc., Netflix Inc., Facebook Inc. and Twitter Inc. will continue growing, even as many believe stock gains will slow as monetary policy tightens and the boost from the tax-overhaul fades. In fact, technology stocks remain among the best-performing sectors in the S&P 500 even after recently tumbling on fears that the White House could move to curb foreign investment in technology firms and sliding at the start of the quarter on worries the sector could get hit by tighter regulations.

The five largest publicly traded companies in the world by market capitalization are now all tech-related, a stark change from 2009, when firms such as General Electric Co. and Exxon Mobil Corp. dominated the list. Nearly half of global fund managers now say betting on the FAANG names -- Facebook, Amazon, Apple Inc., Netflix and Alphabet Inc. -- and their Chinese equivalents ranks as the most crowded trade in the market, according to a June survey from Bank of America Merrill Lynch. That marked the highest share of investors since 2015 to agree that one trade was becoming too popular.

Tech's growing dominance has skewed the broader S&P 500 away from so-called defensive stocks -- sectors such as utilities, consumer staples and health care -- that investors have traditionally gravitated toward during bouts of market volatility. That has left some analysts worried investors in index-tracking funds could be dangerously exposed to a pullback.

The degree of defensiveness within the S&P 500, which Leuthold Group calculated by using the percentage of the index's market capitalization comprised of defensive sectors, has fallen nearly 60% from 1991 through early June, according to the group's data. That has increased the weighting of highflying growth stocks within the S&P 500, reducing its overall effectiveness as a diversified portfolio for investors who opt to passively track the broad index, Mr. Paulsen said.

The S&P 500 is "not the same index it was when your father bought it," he added.

Some investors have begun viewing technology stocks as a safety play, betting that companies that have produced double-digit percentage gains this year will be able to continue growing earnings even under more restrictive global trade conditions. While the broader stock market tends to take a hit following the announcement of a trade action, technology stocks are among the best-performing stocks in the 30 days after a trade action is announced, implemented or ended, according to BofA Merrill Lynch data going back to 1995.

To many investors, the technology sector's track record of earnings growth supersedes risks like trade tensions and the possibility of tighter regulations. Amazon's quarterly profit topped $1 billion for the first time in the most recent quarter, while Facebook's earnings soared even after its user-data crisis and Microsoft posted double-digit growth in profit and revenue.

"Long term, it looks like a legit growth story," said Paul Christopher, head of global market strategy for Wells Fargo Investment Institute.

Yet some analysts worry that, with uncertainty swirling over whether the U.S. will ratchet up trade tensions with China, the European Union and others, investors have mispriced the risk that the sector faces.

Technology companies in the S&P 500 have the highest share of overseas revenue of the broad index's 11 sectors, with a foreign-exposure level of about 59%, according to FactSet and BofA Merrill Lynch data. That is greater than the broader S&P 500, which gets about one-third of its revenue from overseas and indirect exposure via commodities, the bank added.

That makes the sector particularly vulnerable to restrictions on trade and investment. The Nasdaq on Monday posted its biggest one-day decline since April after reports suggested the Trump administration was planning to curb foreign investment in U.S. technology firms. The tech sector's high exposure to foreign revenue also exposes it to swings in the foreign-exchange market: Should the recent rebound in the U.S. dollar continue, that could hurt multinationals whose goods will become more expensive to foreign buyers, and overseas revenue will be worth less when converted back into dollars.

Even as investors say technology firms as a whole appear to be on more stable footing than they were at the height of the dot-com era in 2000, many remain cautious, citing the tendency for the stock market to contract when it is led by just a handful of outperformers.

"Whenever the market narrows like this and everyone wants to own the same stocks like the [FAANG] stocks, there is a feeding frenzy that can go on for a while," said Mike Balkin, a portfolio manager at William Blair. "When it ends, it usually doesn't end well."

Write to Akane Otani at akane.otani@wsj.com and Michael Wursthorn at Michael.Wursthorn@wsj.com

(END) Dow Jones Newswires

June 29, 2018 05:44 ET (09:44 GMT)

Copyright (c) 2018 Dow Jones & Company, Inc.