Is Big Tech Back in the Driver’s Seat?

Do you remember when big tech was the ONLY place to invest?

Let’s rewind to the days before half the world closed its doors. From the end of 2018 to the pre-pandemic peak, the S&P 500 Information Technology Sector rose 65%. The Communication Services Sector, which sported 20% weights to both Alphabet and Facebook, jumped 40%. The S&P 500 itself climbed 35%. Not a bad year for investors, right? So long as they had their money in the right place, that is.

Over that 13 month period, every other sector underperformed the index.

Every market historian knows that the bulk of historical index returns are generated by a handful of names (that’s why we focus so much on identifying relative strength). Rarely, though, has that phenomenon been so readily apparent as it was that year, when more than 80% of sectors lagged the index.

COVID wasn’t the end of that story. In fact, forcing millions of people and their employers to embrace a digital transition was just gasoline on the fire. In the first 8 months of 2020, the Russell 1000 Growth index surged 45% relative to its Value counterpart.

Then came September 2020.

In just 3 days at the start of the month, growth stocks dropped 10%. Value fell only 4%. We couldn’t have known it at the time, but that day would mark the end of growth’s dominance. Value oriented stocks – especially in the Energy and Industrials sectors – have been in the driver’s seat ever since.

Big tech’s trouble couldn’t have started at a more logical place – the same place trouble began more than 20 years ago. Tech’s relative strength peaked exactly at the monthly highs from the internet bubble. Last time, it resulted in an 80% collapse for the sector, and a run of lackluster performance that didn’t reverse until the financial crisis. The question is, will history repeat itself?

The answer may rest on the path of interest rates. Financial assets have benefited from 40 years of falling interest rates since the early 1980s. Not only have lower rates reduced borrowing costs and helped drive economic expansion, they’ve also forced investors out the risk spectrum. An investor that once was happy with a risk-free Treasury yielding 6% hasn’t had that option since the turn of the century. Instead, they’ve had to allocate funds towards riskier asset classes – high yield bonds, real estate, stocks, etc. And because interest rates are a primary component of the discount rate used to estimate the value of most assets, stocks with higher long-term growth expectations have disproportionately benefited.

That 40-year run for rates may be at an end, though. With inflation far above the Federal Reserve’s 2% target, they’ve raised short-term borrowing costs at 9 consecutive meetings since last March. Interest rates across the curve have risen to levels not seen since the Financial Crisis.

Growth stocks felt the consequences in 2022. Information Technology, Communication Services, and Consumer Discretionary (dominated by Amazon and Tesla) were all leaders on the downside. Value and risk-off sectors, meanwhile, held up significantly better.

In 2023, though, the narrative has reversed. Tech, Communications, and Discretionary are each up double digits, while everyone else is in the red.

Interest rates again are largely to blame. The 10-Year Treasury yield has retreated from last year’s highs and is threatening to fall below support. If it does, big tech is set to remain in the driver’s seat.

Besides a resurgence in yields, what’s the biggest risk to this narrative? The ‘why’ of interest rates breaking down.

In the first few months of the year, economists and investors began to believe the Federal Reserve was close to achieving a so-called ‘soft landing’, i.e. controlling inflation without causing a recession. If so, rate hikes would soon be at an end, and investors could be more confident in valuing a growing company’s prospects.

With the failure of Silicon Valley and Signature Bank, though, that soft landing scenario seems unlikely. Deposits are flowing out of banks across the country and into money-market funds, and banks will almost certainly respond by pulling back on credit issuance. Those types of credit crunches often lead to recession.

Markets have responded by pricing in a series of rate cuts by the Fed in the back half of this year, and the prospect of lower rates brings with it all those growth stock tailwinds of the 2010s. While Financials, Industrials, Energy, and Materials sectors have all dropped since SVB’s collapse, Tech, Communications, and Discretionary are doing just fine.

The question is, will Powell & Co. play along? Powell isn’t forecasting cuts this year, and neither are his colleagues. But they don’t sound too confident in a soft landing either. Instead, they continue to point towards the risks of removing restrictive policy too early, lest they repeat the mistakes of the 1970s. Their mandate is to maintain price stability and full employment, and they can’t achieve the latter without first ensuring the former. In other words, Powell’s Fed may not offer the same monetary support that we’ve grown accustomed to during recent recessions.

If that’s the case, it may not matter which sectors are showing relative strength – they’ll all be facing some serious pressure. Bear markets that coincide with recessions often take years to find a bottom. And you’d be hard-pressed to find one that’s bottomed before the recession even began. That’s the crux of the bear case for stocks.

Here’s one final chart to chew on: Tech is back above those monthly, internet bubble highs, and it’s set to challenge the weekly level.

If Information Technology, the biggest sector in the index, is setting new all-time relative highs… well, good luck defending that bear case.

Better Beneath the Surface

It’s a market of stocks.

Sometimes we can lose sight of that simple fact. We live in a world dominated by indexes. The media tells us all about the S&P 500, the NASDAQ, and the Dow Jones Industrial Average. Our portfolios are benchmarked against those same indexes, or ones just like them.

It’s hard to blame anyone for this flaw – huge baskets of stocks are the easiest way to describe market action, especially in a world where time always seems to run short. The problem is, the indexes most of us see aren’t perfect or complete descriptors. Most are weighted by market capitalization, meaning the largest companies like Apple and Microsoft matter the most. The Dow Jones Industrial Average is allocated by price, so the stocks with the highest price per share hold the largest weights. Both approaches have their merits, but they can obscure what’s happening beneath the surface.

Right now, those approaches are hiding strength.

Continue reading “Better Beneath the Surface”

(Premium) November Information Technology Outlook

Information Technology broke down relative to the S&P 500 as we expected, but the weakness didn’t accelerate. The sector is still battling with resistance from two decades ago, and, barring a short-term trade, there’s really no reason to be overweight the group until we’re above those 2000 highs. The question is, should we be neutral or underweight? Based on what we’re seeing in other growth areas of the index, we still think the higher probability is further declines for this ratio. We’ll have more conviction if we see those April 2021 lows broken.

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The Total Domination of Tech Stocks

It’s no secret the last 12 months have resulted in healthy gains for stocks. From December 31, 2018 through Friday’s close, the S&P 500, including dividends, returned more than 31%. The rally has been broad, too. Excluding Energy, which makes up a mere 4.3% of the index today, no sector returned less than 18% over the period.

For those intent on outperforming the index though, 2019 may well have presented a challenge. Of the 11 sectors, only one outperformed the S&P 500. Check out the performance derby – S&P in black – since the end of last year.

Sector Derby.PNGInformation Technology has been a dominant force, to say the least. The group led during the first half of the year, then almost single-handedly dragged the entire index higher over the second. Thus, after a major decline in the fourth quarter of 2018 that ended on Christmas Eve, the S&P 500’s largest sector (almost 1/4 of the index) has returned nearly 60%.

If you’ve only been watching EPS metrics, Tech’s outperformance likely seems odd. Their earnings growth was virtually flat for 2019 – slightly less than the S&P 500 overall. And even though earnings growth is expected to rebound in 2020, Tech is seen as an underperformer once again.

2020 EPS Growth by Sector.PNG

If you’re looking for fundamental justification, the Friday publication of FactSet’s Earnings Insight provides some explanation. Twenty tech companies have issued positive guidance for the fourth quarter. In the last 4 years, only the first quarter of 2018 had more – a quarter set apart by a significant cut to the corporate tax rate.

Tech Positive Preannouncements.PNG

Perhaps this renewed macroeconomic confidence will turn into positive earnings revisions for the remainder of 2020 and offset the multiple expansion we’ve witnessed over the last year.

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.

Assessing the Damage in Tech

It’s been a wild few weeks for markets. Between a ‘hawkish rate cut,’ new tariff threats, and wrapping up the bulk of earnings season, stocks, bonds, and commodities have all made major moves. Precious metals rallied, interest rates dropped, and U.S. stock indexes fell below what had been important support. With the index below a key level, it’s a good time for a health check on the market leaders.

The Information Technology sector has been the most important driver of equity returns. After U.S. stocks peaked in January 2018, Tech continued to drive higher, setting new highs throughout the summer. Again this year, Tech set new highs in early April, weeks before the broader index. At more than 20% of the S&P 500’s market cap, it has the ability to make or break rallies. So after our most recent selloff, should we expect Tech to continue leading us higher?

The Systems Software Industry has been a big part of Tech leadership. It’s been in a strong uptrend for most of the last 5 years, and even now is well above an upward-sloping 200-day moving average. On the most recent pullback, it held its swing high from April, which also represents the 161.8% extension from the Q4 2018 decline. The next cluster of extensions to the upside lies near $2800. In order to reach that level, the industry will need to overcome a pretty big divergence in momentum. A sustained break of $2422 would indicate it needs to work off the divergence before it can resume its trend higher.Systems Software.PNG

Data Processing has been just as strong, and it looks about the same. The upside extensions are just over $1400, while near-term support is at $1216. The momentum divergence is concerning, but, similar to Systems Software, managing to stay out of oversold territory on the most recent pullback is a sign of strength.Data Processing.PNG

Another group that falls into the same category is Internet Services and Infrastructure. Again, momentum diverged at the most recent highs, but prices are still above support. The risk-level to watch is $936, with $1100 looming as a possible upside target in the near-term.Internet Services and Infrastructure.PNG

The damage to Communications Equipment was more meaningful. The industry is still trading above an upward-sloping moving average and major support from the 2018 highs, but momentum is flashing a warning sign. Prices never even got overbought on the most recent high, and dropped into oversold for a second consecutive time last week. It could take some time to work off these issues, but as long as it stays above support near $225, the long-term uptrend will remain intact. If the price can get back above $258, the extensions at $300 are within reach.Communications Equipment.PNG

The Application Software industry got rejected at the intermediate and shorter-term extension cluster near $220. Momentum had diverged as the group set its most recent high, and then got oversold on the pullback. The long-term uptrend is intact above $194, but it might take some time to improve momentum’s signature before it heads to higher levels.Application Software.PNG

Semiconductor Equipment stocks were some of the weakest last year. They peaked in the second quarter and were nearly cut in half by the December lows. But momentum diverged positively at the December lows, and since that false breakdown, the industry has headed much higher. Momentum is now in a bullish regime, and prices have managed to hold important support at $1040. Working through resistance from last year’s top will be no easy task, but if Semi Equipment can reestablish itself above $1200, the next extensions are quite a bit higher.Semiconductor Equipment.PNG

Several industries lack a clear trend. Both Semiconductors and Electronic Equipment Instruments are trading near flat 200-day moving averages. In both cases, momentum is sending mixed signals, and the trading ranges are pretty clearly defined.Semiconductors.PNG

Electronic Equipment.PNG

Technology Hardware, Storage and Peripherals is fighting to stay out of a downtrend. The 200-day moving average is downward-sloping, but prices have spent most of the past few months trading back above it. The false breakout in July and momentum’s failure to get overbought are trouble for bulls, but after more than a year of mostly sideways trading, there are plenty of near-term support levels. This chart is likely to stay messy until a break of the trading range is confirmed by momentum.Tech Hardware.PNG

On the whole, Tech is still pretty healthy. Uptrends remain intact for the strongest industries, and one of the weakest has seen substantial improvement. Momentum, though, is sending caution signals in nearly every group. It might just take some time to clean up the divergences, but we have clearly defined support levels that will give us a heads up if the trends are changing.

See things a little differently? Let’s talk about it

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.