The Sector Rotation Out Of Tech Continues

Another Bad Day For Tech

Tech stocks had a terrible day as the Nasdaq was down 0.85% and the S&P 500 tech sector was down 0.87%. The defensive real estate, consumer staples, and telecom sectors were all up more than 1%. This is a sign the sector rotation continued in a somewhat flat day as the S&P 500 was only down 0.29%. Facebook stock was up 0.53% as the selling pressure may have peaked. The worst of the big tech names were Amazon, Netflix, and Tesla. Just after I mentioned Amazon not having any fundamental issues, the company’s stock fell 4.38% on the news that President Trump wants to go after the company over its sales tax policies and its contract with the USPS. The White House said there aren’t any new policies to announce, but the news story increases the odds of further action at some point in Trump’s term.

Bond Vigilantes Coming For Tesla

As you can see from the chart below, Tesla’s bonds have sold off along with its stock as investors are worried about the firm’s ability to produce Model 3 cars, sell them profitably, and see demand grow. What has been working for them is the ability to raise capital via equity. With the stock’s 7.67% decline on Wednesday, it’s now down 27.88% since February 26th. This makes the stock’s decline a sell-fulfilling cycle. The less confidence investors have, the lower the chance of success. Tesla has been lucky that the credit and equity markets have been favorable in the past 8 years. It’s doubtful the firm would be able to stay solvent in a risk off period. That’s shocking because the company was almost shuttered in 2008. 10 years later, the firm still is far from being consistently profitable. The latest negative headline about the firm is the use of automation in production where it is inefficient.

Netflix Is An Important Signal

Netflix is probably the face of FANG right now because prior to the recent selloff its stock was up 73% year to date. It has been the big consumer tech name with the most momentum. It fell 4.96% on Wednesday and is down 14% from its peak. Just like how investors are trying to figure out if this is a correction or a bear market in equities, investors in Netflix are trying to understand if this is profit taking or the start of a new downtrend. Some might think it’s obviously profit taking because no major negative catalysts have occurred in the past few weeks. However, sentiment is possibly more important than fundamentals for this stock. To show why I think this, I’ll ask: Did Netflix show enough fundamental improvement to justify a 73% move in 2.25 months? Probably not. The momentum trade will keep going until the market exhibits a phase change. With the Fed raising rates 3 or 4 times this year, a change can come sooner than later. The action in Netflix will tell you where the overall market is headed and which sectors will do well.

Hard Data Weakening

The economy improved in 2017 as the global synchronized economic boom took place. The hard data shows this as there was a normal cyclical improvement in the midst of this slow growth economic expansion that doesn’t seem to ever want to end. The big story was how the soft data exploded as businesses were excited by the tax cuts and regulatory overhaul that were promised after President Trump was elected. While we got most of what was expected, the optimism still probably wasn’t justified. With the economy improving because of rebuilding efforts after the hurricanes and the soft data coming back down to earth, the two recoupled in late-2017.

One of my predictions for the year was that hard and soft data would stay correlated and improve. That forecast doesn’t look good as the recent hard economic data in February was poor, but the surveys showed improvement. Because we aren’t getting another round of fiscal stimulus, I can’t see soft data coming close to the previous peak seen in the chart below. I can see the hard data weakening in the next couple of months since the ECRI forecast expects a weak start to the year.

Focusing on the hard data, it’s amazing to see how the QE and low interest rates haven’t had much of an effect on growth. There have been several phase changes in this expansion as some years look like growth will finally get back to what it used to be and other years make it look like a recession is coming. This pattern of slow stable growth with fits and starts hasn’t been correlated with monetary policy. Even with 3 rate hikes and no QE, the economy was strong in 2017. The domestic economy disregarding monetary policy while being affected by the global trends furthers my support of the notion that the U.S. economy is going to see strength and weakness in 2018 despite the easy fiscal policy. The good news is that there hasn’t been a recession in 9 years; the bad news is 3% GDP growth is elusive.

Weighting Matters

The point of the Shiller PE is that everything is supposed to mean revert. Margins and multiples are expected to fall back to normal regardless of the sector weighting. That being said, I think sector weights can be a long term shift that doesn’t mean revert. Specifically, it’s tough to claim that the tech sector will lose market share in the long term given how important these firms are to our lives. The other more likely scenario is that the tech stocks with high multiples and margins will see a decline. That being said, it’s still valuable to review the valuations using a sector neutral comparison.

As you can see from the chart on the left, the U.S. stock market is much more expensive than the global market. However, the chart on the right shows that the valuations are closer when you adjust for sector weights. If you still think America is expensive, you think one of the following: tech stocks will see a decline in margins or multiples, tech will see a loss of share in America, or tech will gain share in the rest of the world. Ultimately, selling U.S. stocks because of valuations is penalizing the stock market because U.S. tech stocks dominate the global marketplace.

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