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Technology stocks have been skyrocketing in 2023, far outpacing the broader market. New data analysis reveals that the tech sector’s high profit margins are fueling this rally.

According to Q2 earnings research from leading financial data firm FactSet, the S&P 500 information technology sector is estimated to post a 22.4% net profit margin for the second quarter of 2023. This represents only a slight decrease from tech’s 5-year average net margin of 23% — still the second highest of any sector.

“The last few years have been remarkably good for this sector, and yet they continue to show the second highest margins of any S&P group in the second quarter,” said Nicholas Colas, co-founder of independent investment research company DataTrek, in a note this week. “While Tech’s net margins are down modestly versus the 5-year average, they are holding in well.”

S&P 500 Margins Declining But Tech Defies Gravity

In contrast to tech’s strong profitability, the overall S&P 500 index has seen declining margins over the past two years. Net margins for the index peaked at 13% in Q2 2020 but have now fallen to 11.1% in Q2 2023, roughly equivalent to the S&P 500’s 5-year average of 11.3%.

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“No wonder the S&P 500 is still 5 percent away from its all-time high, set over 18 months ago in early January 2022,” observed Colas. “Margins have been solid — anything over 10 percent is still great — but they certainly have not been stable.”

The data indicates tech companies have maintained earnings power even as broader macroeconomic challenges pressure profits. This relative outperformance helps explain why technology stocks have skyrocketed over 46% year-to-date, the best gains of any S&P sector.

Surging Tech Stocks Push S&P 500 Higher

Bolstered by tech’s standout margins, the S&P 500 has rallied 19% overall so far in 2023, recovering nearly half of its 2022 losses. Tech now makes up over 27% of the index’s market capitalization, the largest of any sector.

“Tech’s gravity-defying margins are a key factor powering the S&P 500’s continued march higher, even with lingering questions around market-wide profitability,” said investment strategist Mary Johnson of WealthSecure Advisors. “The tech heavyweights have simply proven more resilient than the rest of the pack.”

Apple, Microsoft, Amazon, Alphabet and Meta alone account for over 22% of the S&P 500’s total value. With big tech emitting strength, concerns around slowing economic growth and consumer spending have been overshadowed.

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Healthcare Drags With Worst Margin Decline

On the flip side, FactSet data shows the S&P 500 healthcare sector suffered the largest profit margin decline compared to its 5-year average. Healthcare companies are estimated to post just 7.6% net margins for Q2 2023, down a sizable 2.8 percentage points from the 10.4% 5-year average.

“This margin compression is likely due to a combination of rising costs and regulatory scrutiny,” explained biotech analyst James Wilson of Canaccord Genuity. “While the sector faces unique challenges, this level of margin deterioration is worrying, especially if it persists or worsens.”

With healthcare stock performance flat year-to-date, the sector has failed to keep pace in an otherwise bullish market. This reflects concerns around the fundamentals and growth trajectory for healthcare firms. Ongoing political efforts to curb drug pricing powers may continue to constrain profitability.

Industrials Outperform But Need Recession Resilience

Among other S&P industry groups, the industrials sector posted the largest gain versus its 5-year margin average. Companies in areas like aerospace, construction and manufacturing saw estimated Q2 net margins of 13.9%, up 2.5 percentage points from the historical norm.

But in a note to clients, DataTrek’s Colas cautioned: “We doubt industrials can see a large secular improvement in their valuation until they get through a recession with similar levels of profitability.”

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If industrial firms can demonstrate resilient earnings through the next market downturn, it may improve the sector’s historically discounted valuation and support further stock rallies. For now, analysts advise monitoring margin trends closely across cycles.

Margin Data Offers Market Insights

This mid-year profitability snapshot offers insights into recent S&P sector rotations and performance divergences. While investors weigh future growth prospects, current margins provide useful clues around what’s fueling today’s leaders and laggards.

“We expect margin trends to remain top-of-mind for analysts and investors alike as they handicap earnings potential for the second half of 2023,” said Wilson. “Any major positive or negative shifts could certainly impact sentiment around tech, healthcare and other sectors.”

With the S&P 500 still 5% below its January 2022 peak, margins may need to stabilize or improve to drive fresh record highs. But if tech profitability persists near the top of the pack, it could give the sector and overall large-cap stocks more upside runway.

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