Apple Stock Drags The Market Lower

Monday’s market action was like Friday’s action in that the S&P 500 closed nearly flat (down 0.1%) and the Nasdaq underperformed as it was down 0.52%. Adding to the weakness in the riskiest markets was bitcoin and ethereum which cratered in the afternoon. Bitcoin fell from $2,997 to $2,519. Some exchanges had bitcoin exceeding the $3,000 milestone. Ethereum fell from $415 to $344. The entire cryptocurrency space is worth $107 billion; bitcoin has a 40.4% market share. Even though cryptocurrencies are supposed to be a safe haven to run to if the dollar crashes, I think comparing them to high beta stocks is the correct way to view them because of the parabolic move upward they’ve had. At this point, speculators are dominating them.

I would describe the past two days as a cross between ‘risk off’ and sector rotation out of tech stocks. The Nasdaq had its biggest 2-day decline since December which isn’t saying much because it’s been going up in a straight line all year. About 75% of the decline in the Nasdaq has been caused by the big 5 tech names. As you can see from the chart below, Apple’s decline represents 28% of the move as Apple is down 6.17% in the past two days. This effect on the market is why I cover Apple stock as if it’s a macroeconomic factor. The iPhone release in the fall is the biggest product launch by far for the S&P 500. The stock could rally this summer as anticipation mounts and then selloff when the product is announced (buy the rumor, sell the news).

I don’t think the long-term fundamentals are sound for Apple because the smartphone replacement cycle is lengthening. It increased from 25 months in 2014 to 31 months in 2016. At first, it was thought that the ending of the two-year smartphone contracts could make people upgrade more quickly, but with the commoditization of the product, it may spur less upgrades as the devices become more future resistant. The end of the subsidized model by the carriers should pressure prices on devices. Consumer electronics prices have come down historically. As you can see from the chart below, Apple was able to up-sell customers in Q1 by offering more storage at the second upgrade level. For example, an iPhone 7 Plus 32GB costs $769; the next level for $869 has 128 GB. The increased price and storage could backfire on Apple by lengthening the upgrade cycle as many consumers upgrade when they run out of storage.

The only catalysts for the selloff in Apple stock were downgrades based on valuation. I don’t see a near term end in the tech rally due to such innocuous news releases. I think this is a temporary selloff in tech even though I’m bearish in the intermediate term. We’d need a string of bad earnings results to have a sustainable downturn. The big 5 tech stocks have seen their valuations stretch, but their multiples are much more reasonable that the tech bubble of the 1990s. One of the possible catalysts for this two-day selloff in tech can be seen in the chart below. As you can see, there has been large outflows in the S&P tech ETFs at the end of May and the beginning of June. The selling in May hadn’t caught up to the market until Friday. To summarize, my point is that the investor crowding into the big 5 tech names will cause pain when panic ensues due to a change in fundamentals. We’ve seen a preview of how Apple can push down the market recently. If the underlying business shows weakness instead of just the stock, the effect on the market will be larger and last longer.

As I have mentioned numerous times in past articles, the factor investing strategy can blow up in the faces of investors using that strategy because these investors have less conviction than regular investors in stocks. For example, with the selloff in Apple, those who believe in the business will buy the dip. If the long growth factor sells off sharply, what confidence does an investor have that it will improve? There’s no specific business that these investors are buying into. The S&P value and growth long-short factors saw their largest 1 day move since May 2009 on Friday. This was a 5.9 standard deviation move based on volume over that period. With most investors leaning long, a reversal can cause stocks to fall more than they should. If this selloff was caused by a substantial news event or earnings disappointment, it could have be more violent. The problem with the Fed supporting the market is that everyone goes long to ride its coattails. This makes it more vulnerable to a crash. Short sellers and corrections are healthy for the market.

Besides technology making up a large portion of the S&P 500’s market cap and earnings per share, the chart below shows the U.S. market acts like the MSCI World Information Technology Index. This compares to the Japanese Index which acts like the World Financials Index. I don’t think this is a permanent move; it’s reflective of the fact that America has benefited from the ‘risk on’ trade. This should decouple at some point in the long term because America’s GDP growth is morbid. The factor which supports high multiples is the international sales of American firms especially from the big 5 tech names.

Conclusion

I look at this selloff as a warning of what is to come sometime in the next few quarters. Technically any correction can be a warning of a future crash. The reason why this one is different from others in previous cycles is because of the size of the big 5 tech stocks, the number of traders who are short volatility, and the number of passive investors who are using factor strategies instead of picking individual stocks or using mutual funds. Furthermore, I’m bearish on bitcoin and ethereum in the near term because of how fast they’ve rallied.

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