Wall Street is firing a warning shot on red-hot tech stocks, and many investors don't see it coming

Kevin Frayer/Getty

• Analysts expect the pace of earnings growth in the technology sector to decelerate this year and into 2019.
• That's a key reason why the sector could soon underperform the broader stock market, said Citi's equity strategists.
• "Analysts' forecasts may be too low, but if they are in the right ballpark, such patterns may be disappointing to very long investors," Tobias Levkovich, Citi's chief US equity strategist, said in a note.

Don't panic now, but the red-hot tech stocks that have underpinned the market's gains could be in for a slowdown.

That's according to Tobias Levkovich, the chief equity strategist at Citi, who advised clients to be cautious about the sector.

Complimentary Tech Event

Transform talent with learning that works

Capability development is critical for businesses who want to push the envelope of innovation.Discover how business leaders are strategizing around building talent capabilities and empowering employee transformation.Know More

Among his reasons for this caution was "a very substantive slowdown" in forecasted earnings-per-share growth for the rest of the year and in 2019. This could dim the appeal of tech stocks, which many investors have bought because of their rapid earnings growth and to profit from their upward momentum.

"We do not expect tech names to blow up since a major valuation gap is not in place as was the case in 2000," Levkovich said. "Additionally, we do not envision a substantial equity market decline which would occur if 25% of the overall market cap fell sharply. But, we can perceive IT sector underperformance, something many clients do not appear to be positioned for and would be a problem for relative returns."

In a note on Friday, he said he recognized this was not a popular position to take. Trends like artificial intelligence and cloud computing are here to stay. Additionally, companies like Netflix and Amazon have wowed investors with their business models, which include subscriptions that serve as stable revenue generators, Levkovich said.

However, analysts are not confident that tech will sustain its pace of earnings growth, which has already started to slow.

Citi

These estimates, however, reflect analysts' concerns about sustainable earnings growth rates, not necessarily what exactly could happen to tech companies. Historically, analysts' initial estimates are too conservative and get revised higher as the earnings season nears.

"Analysts' forecasts may be too low, but if they are in the right ballpark, such patterns may be disappointing to very long investors," Levkovich said. "In addition, sector upward earnings revision trends are near highs and could be poised to slide."

Citi

Companies get rewarded from investors when they beat earnings estimates, but the first quarter showed it's not always a bounty. According to FactSet, S&P 500 companies that reported positive earnings surprises gained 0.2% on average in the two days before and after their results. The average over the last five years was 1.1%.

In a late-April interview with Business Insider, Levkovich said last year's jump in equity multiples indicated that stock prices would not see the full benefit of strong earnings growth.

Diving deeper into the sector, Levkovich's valuation models showed that software companies like Microsoft and Salesforce are poised to provide strong relative returns over the next 12 months.

That's not the case for services stocks, however. In addition, Levkovich is cautious on chipmakers because their strong capital expenditure could lead to a deluge of new products that lower prices and eventually profit margins.