7 Of The Top 8 Firms Are In Tech

The stock market ended the month of August positive making it the 10th straight month the S&P 500 was up on a total return basis. In the past two days, it seemed like someone wanted the market to be up for the month as it rallied just enough to achieve that goal. The last North Korean action did nothing to stymie the market as the S&P 500 is within 1% of its all-time high. The VIX fell 5.61% to close the month at 10.59. As you can see from the chart below, this was the 4th lowest monthly close for the VIX since 1990. As you can see, the high is the highest on this list because of the brief worry about North Korea.

Some stats don’t match the great conditions large cap corporations are in. That’s because the small caps aren’t having the same earnings expansion. The chart below shows the percentage of firms which have low interest coverage ratios. These ratios will be an issue when interest rates rise. The majority of the firms seeing low ICRs are small caps. This explains why the 2017 bar is the third highest in this bull market even though S&P 500 earnings are at a record.

The chart below shows that 8 of the top 13 firms by market cap are tech stocks. Even more remarkable, 7 of the top 8 firms are tech. The interesting thing about these mega cap tech names is if you tried to separate the tech sector it would be tough to figure out how to categorize them because they have their tentacles in so many business lines. For example, Amazon is an online retailer, a brick and mortar super market company, a tablet and e-reader company, and a cloud company.

Apple looks like the riskiest of the firms on this list because the company relies mostly on the iPhone. Apple needs to convince consumers to buy their new phone which will have the technology which Android phones have had for a few months. The distinguishing feature of the new iPhone will be the infinity screen which many of the cheaper Android phones already have. The question is how many new product launches will Apple be able to rely on having an increased screen size. Besides beating the competition, Apple needs to make sure old users constantly upgrade their phones every 1-2 years despite their useful life being longer than that. In the long-term Apple appears to have a shallow moat, meaning it’s tough to defend its market share. The other aspect to keep in mind is you don’t want to get excited about the new innovations such as self-driving cars because it will be nearly impossible to make up for iPhone sales declines if they occur. The iPhone is the most profitable product in history; it’s tough to have lightning strike twice.

I like to follow the narratives of both the bulls and the bears to see who is making the most sense. One of the new arguments the bears have put out is that low correlations are negative for the market. The chart below shows the historical correlations along with the S&P 500. Make sure you see that the correlation scale is reversed. The 2000 stock market bubble must’ve had bad internals where the tech stocks were carrying the market. That couldn’t last forever given the high multiples the tech stocks had. I don’t buy into the premise of this chart even though correlations are low once again. There have been many charts in the past 2 years comparing the current levels to the previous two bubbles. I am convinced this cycle is different. I also don’t see why a crash would occur when the economy is exhibiting its fastest growth and S&P 500 firms have the highest profits ever. It’s best to avoid the esoteric charts and focus on the important things: earnings, the economy, and valuations. Trailing PEs will come down with the rising earnings. The high Shiller PE will only start to matter when profit margins start to fall.

The chart below shows my point about the bears being wrong for a while. If you glance at the bottom, you can see the 3% predicted gain for 2017 was made in December 2016. I admit that I was also bearish at the beginning of the year. The point isn’t to criticize anyone who made a wrong prediction as everyone has done so in their life. The key is to learn from the mistake. This wrong prediction stems from using long term valuation metrics to predict short term returns. One year is very short term when looking at valuations. If you’re predicting such short-term moves, valuations don’t matter. The 3% annualized returns for 2017-2021 are still reasonable because that’s more of a long-term time frame.

The part of this prediction which showed emerging markets doing better that domestic stocks was correct. As you can see from the chart below, the economic rebound and record QE has been good for equities around the world as only Russia is down year to date on a total return basis.  Emerging markets have had amazing year as Brazil is up 21%, China is up 28.1%, and India is up 28.5% in US dollar terms. In that case investing based on valuations worked, but the reason they are up this year specifically was because of their economic turnaround, not their low multiples. The obvious question for 2018 is if this performance can repeat itself with less of an acceleration in economic growth and less quantitative stimulus. I would say no, but America won’t necessarily have a bad year if the correct fiscal policy actions are taken in the next 2 months. The government is about to become a drag for the market. It would great if that drag can turn into a tailwind.

Conclusion

The stock market is on a great run. The biggest potential risks in the next 12 months aren’t correlations or even long-term valuations. The biggest risk is rising interest rates and fiscal policy ineptitude. Apple’s iPhone launch might be one of the biggest events for the stock market in September because of how large the company is. Usually the stock falls after the new iPhone is released. Its performance afterwards obviously depends on how well the new iPhone sells.

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