Tech Dominates Factor ETFs
Today was a rare day because as the S&P 500 rose 0.83% to a new record high, the Shiller PE went above 30 for the first time in this bull market. Since the 1880s, the Shiller PE has only been above 30 from August to September 1929, from June 1997 to August 2001, from November 2001 to January 2002, and in March 2002. Market bears are salivating as valuations get higher, making stocks look like a terrible investment over the next 10-years. Unfortunately for the bears, the stock market still looks like it has room to run this summer. As I predicted, tech stocks rebounded from their recent weakness. The Nasdaq rallied 1.42% as it’s only down 1.31% from its all-time high. Apple rallied 2.86% as it recovered some of the losses from the downgrades which said it’s overvalued. Given this exceptional environment for tech stocks, I continue to expect Apple to rally until the release of the new iPhone. The buy the rumor, sell the news trade looks good to go.
In previous articles, I have spoken about my skepticism of factor investing. The Wall Street Journal reported some interesting findings on how these factors are created. It turns out they are mostly tech heavy regardless of what they claim to be. Because tech stocks have become less volatile than the consumer staples industry, they find themselves in growth and value factor indexes. Apple is in 5 low volatility ETFs and 9 momentum ETFs. It’s certainly possible for Apple to be in many types of indexes because it has a dividend, low PE, and sometimes a high growth rate, depending on if iPhone sales do well. Thinking Apple is a low volatility stock is an example of how volatility doesn’t account for business model risk. Clearly consumer staples have less risk in their business models than Apple because there are less technological advancements in this sector than there are in smartphones.
This market is so perverse, when Amazon buys a supermarket firm, it instantly gets a higher valuation. There is no doubt what Amazon has done to retailing is amazing, but there may be too much trust in Jeff Bezos. All the major technology management teams are idolized too much. Getting back to the point on factor investing, Alphabet is in 7 low volatility ETFs and 3 momentum ETFs. The concept that Alphabet, the firm investing in self-driving cars could be in a low volatility factor would shock investors if you mentioned this 5 years ago. While Alphabet is an innovative company, the idea that it is in a low-volatility business is suspect. Microsoft, the company which has managed to be at the forefront of the original tech bubble and this one, is in 11 low volatility ETFs and 4 momentum ETFs.
The chart below shows this new trend in remarkable fashion. As you can see, tech stocks are now 11.3% of the low volatility PowerShares ETF. To be fair, Google and Apple are much more innovative than the typical low volatility firms who might be in this index like Intel or Cisco. Investors have realized that many value stocks in the tech sector are dying businesses. It’s much better to be a growth firm than a value firm in tech. It could be problematic if these mega-cap firms see their growth disappear because then they will lose their value and growth monikers simultaneously. Apple faces this risk if the new iPhone misses sales expectations and the temporary repatriation tax cut doesn’t get passed.
Economic Reports
My prediction about the U.S. Macro Surprise index continues to come true as it falls without effecting the stock market. The chart below gives a great historical context about why this index isn’t forecasting impending doom. As you can see, the index was highly positive in the middle of 2008 despite the economy being in a recession. This chart tries to make it look like the economy is as weak as in 2011 when the U.S.’s debt was downgraded, but the reality is this index simply reflects the fact that the estimates for the economy were overzealous. Economists expected a potential 4% GDP growth reading because of the weak initial Q1 report, but after the initial reading was upgraded from 0.8% growth to 1.2% growth and the April and May economic reports came in, it seems only 2% growth will occur. This is short term noise because most economists are only expecting 2017 GDP growth to be slightly above 2%. Because of the seasonality and realization that the economy isn’t rebounding sharply from Q1, I expect the Macro Surprise index to rebound in July. This index is much to do about nothing.
As I have been forecasting for a few months, the consumer confidence surveys have been coming down across the board. The chart below shows the economic confidence index hitting 0 for the first time since November 13th, 2016. The question is if this weak confidence will translate into weak consumer spending. I will be watching the retail sales reports closely.
As you can see from the chart below, the May labor conditions index was updated. It showed deceleration from the 3.7 peak in April, but it’s still positive. Despite the weakness in 2016, the jobless claims and BLS reports weren’t as bad. This counts as a false positive recession reading to me. Obviously, a negative result is bad, but it has had some false flags. If it falls negative in June, I would describe this as a warning sign opposed to a red flag.
Conclusion
The labor market remains decent, but consumer confidence is falling. The macro surprise index being very negative is not a reason to panic. The concept that tech stocks are safe is illogical if you look at their business and competition and not just their stocks. If a risky company’s stock has low volatility that doesn’t justify putting a high amount of your wealth in the firm. It’s probably the worst possible justification I can think of because risky companies usually correct hard after rallies.
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