The rally in tech is set to fade after a red-hot start to 2023, but analysts say one area will keep thriving

• The tech sector after last year's bear-market plunge is the best performing in the S&P 500 this year.
• Analysts tell Insider the broader sector is too expensive even with pullbacks, as the market faces more rate hikes.

Investors excited about AI in the unfolding ChatGPT era have helped cultivate blazing outperformance by tech stocks in the US stock market, but analysts say headwinds are stiffening for the pricey sector as the Federal Reserve signals interest rates are going even higher than anticipated.

The S&P 500 Information Technology sector has gained roughly 11% this year, making it the best-performing of the 11 groups tracked on the S&P 500. The sector at one point climbed 18% since hitting a low in October, finding fuel from an investing craze around AI, expectations the Fed may start cutting interest rates and a fall in Treasury yields.

The tech-concentrated Nasdaq Composite has picked up about 6% this year following last year's plunge of 33%.

But this week appeared to serve a fresh reminder the Fed is far from done raising borrowing rates. The S&P 500's year-to-date gain was on the edge of being wiped out Friday. Fed Chairman Jerome Powell earlier in the week signaled a much higher-for-longer scenario for the fed funds rate, currently at 4.5%-4.75%.

Data on Friday showing strong hiring in the US in February while wage growth slowed eventually spurred a broad selloff, driving tech stocks in the red for the week.

"At the end of the day, no matter what is happening in the economy, now everything is looked through the prism of what the Fed will do," Irene Tunkel, chief of US equity strategy at BCA Research, told Insider in an interview.

The message, analysts say, is clear: steepening rates bode poorly for tech.

"When you talk about stocks with a promise, a promise means that all of these earnings and happenings are still far in the future. Even [the] chatbot that Microsoft has released is not fully operational yet. So [even higher] interest rates are particularly damaging to hopes and dreams," Tunkel said.

The S&P 500 Information Tech sector recently traded around 22 times forward earnings, said Tunkel. "Tech is not cheap anymore."

Michael Skordeles, a senior US macro strategist at Truist Advisory Services, told Insider that now may not be the best time to step into the broader tech sector.

"As we look out farther in 2023, tech stocks are fat on a number of levels, but primarily hiring," he said. Companies whose ranks swelled during the height of the pandemic have been laying off thousands of people recently as they work to right-size their businesses.

"From an investor's standpoint, that's low-quality earnings. You got there not because you grew revenue but because you were able to cut costs…the question is, 'How long can you keep that up?," said Skordeles.

Stocks overall have reset lower from recent peaks. "But valuations within tech, broadly, are still around 20 times forward earnings. You say, 'That's still kind of rich,'" he said.

First-quarter earnings growth for the tech sector is expected to decline by 12% year over year compared with a 6% earnings slowdown anticipated for broader S&P 500. Tech-earnings growth softening at twice the pace of the overall market serves as part of the hesitancy to recommend a jump into tech stocks now, Skordeles said.

'The best of the worst'

But within the tech sector, BCA is overweight on the software and services industry. "I prefer software stocks. I call them the best of the worst," said Tunkel, without giving individual names.

Software companies have the most stable earnings growth in the sector and are benefiting from long-term trends such businesse migrating to cloud services. "And now AI, all of these stocks, mostly live in software," she said.

Semiconductor makers provide computational capacity for AI and cloud-based operations. "But still, it's derivative. They have many other business lines which are suffering," she said.

Skordeles also said there are relatively more attractive buying opportunities within software with the expansion in AI, cloud services and gaming. Hunting within industrial tech stocks, or tech companies with end markets in areas such as defense and autos, is also worth some time as those companies are further along in the recovery process, he said.