Mega-Cap Tech Companies Retake The Spotlight As Bulls

Stocks have pushed to new highs yet again, given more positive signs of rising global GDP, strong economic reports here at home, another quarter of solid corporate earnings reports (especially those amazing mega-cap Tech companies), and an ever-improving outlook for passage of a tax reform bill. Likewise, inflows into U.S.-listed exchange-traded funds continued to reach heights never before seen, with the total AUM in the three primary S&P 500 ETFs offered by the three biggest issuers BlackRock, Vanguard, and State Street (IVV, VOO, SPY ) having pushed above $750 billion. On the other hand, discussion on Monday of a potential “phase-in” period for lowering tax rates has had some adverse impact on small caps this week, given that they would stand to benefit the most.

Nevertheless, I still see a healthy broadening of the market in process, with expectation of some rotation out of the mega-cap Tech leaders (despite their incredible surge last Friday) and into attractively-valued mid and small caps. But that dynamic has suddenly taken a backseat (once again) to those amazingly disruptive Tech juggernauts, who simply refuse to give up the limelight. Turns out, elevated valuations, unsustainable momentum, and the “law of large numbers” (hindering their extraordinary growth rates) don’t seem to apply to these companies, at least not quite yet. Their ability to disrupt, innovate, take existing market share, and create new demand seems to know no bounds, with infinite possibilities ahead for the Internet of Things (IoT), artificial intelligence (AI), machine learning, Big Data, virtual reality, cloud computing, e-commerce, mobile apps, 5G wireless, smart cars, smart homes, driverless transportation, and so on….

Still, the awe-inspiring performance and possibilities of these mega-cap Techs notwithstanding, longer term I remain positive on mid and small caps. Keep in mind, in many cases the growth opportunities of these up-and-comers are largely tied to supplying the voracious appetites of the mega-caps. So, it is a way to leverage the continued good fortunes of the big guys, who eventually will have to pass the baton to other market segments that display more attractive forward valuation multiples.

In this periodic update, I give my view of the current market environment, offer a technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals-based SectorCast rankings of the ten US business sectors, and then offer up some actionable ETF trading ideas. In summary, our sector rankings still look bullish, while the sector rotation model also maintains its bullish bias. A steady and improving global growth outlook continues to foster low volatility and an appetite for risk assets, while low-interest rates should persist. Notably, BlackRock recently posted a market outlook with the view that the US economic growth cycle may continue for years to come, and I agree – so long as the worldwide credit bubble doesn’t suddenly spring a leak and upset the global economic applecart. Read on....

Market overview:

Stocks just seem to go up almost every day while volatility remains low, so as MAD Magazine’s Alfred E. Neuman always used to say, “What, me worry?” Rather than being concerned about their investments, Americans have been free to focus on other pastimes, like the MLB World Series. Here in Santa Barbara, which is not too far from Los Angeles, there has been a lot of excitement about the Dodgers playing for the title. Of course, it would have been a huge financial boon for TV if the Yankees had won their Game 7 ALCS against the Astros:  NY vs. LA, the two biggest cities, East Coast vs. West Coast, Wall Street vs. Hollywood, the classic rivalry between two storied franchises for the first time since 1981. But alas, it was not to be, and we are all happy for Houston to make the series – and to actually win it last night! – especially after its epic flooding disaster. Ultimately, the Astros would not be denied, pulling off another Game 7 win.

Although I now live near LA, I actually started my career in Houston in the oil industry as a structural engineer for Gulf Oil in the early ‘80s. In fact, I was just visiting Houston about five weeks ago, shortly after the floods, and I must say I was amazed at how quickly the city has returned to business-as-usual. Houston Strong, no doubt about it. And speaking of Gulf Oil, the company was acquired a few years after I joined them by Standard Oil of California for $13 billion in the largest takeover in corporate history at the time, and the combined entity was renamed Chevron Corp. Back then, you could buy a major oil company with an abundance of real assets in the ground for $13 billion, but today that much money can’t even buy a 55-person company like What’s App, a free mobile messaging app that sold to Facebook for $19 billion a few years ago. Yes indeed, the stock market is quite a bit higher now than in 1985. I often write about the Federal Reserve’s monetary policies of ZIRP and QE creating financial asset inflation….But as usual, I digress.

Although breadth has been generally good and performance dispersion wide, which is healthy for the sustainability of the bull advance, last Friday was all about those mega-cap Tech names, especially FAAMG – Facebook (FB), Amazon.com (AMZN), Apple (AAPL ), Microsoft (MSFT), Google (GOOGL) – led by Amazon’s +13% jump after its incredible earnings report and Apple’s selling out of iPhone X within minutes of accepting orders. In sum, the five FAAMG stocks added a combined $181 billion in market cap on that single day (with Jeff Bezos personally adding $10 billion in net worth to become the world’s richest person), and all five hit new highs. After stocks had pulled back in worried anticipation of those big-Tech earnings reports, the end result was a big relief rally. While the S&P 500 was +0.81% for the day and the Russell 2000 +0.72%, the Nasdaq Composite crushed it, up +2.2%, and the more concentrated Nasdaq 100 was up an incredible +2.9% for its biggest single-day gain in two years, driven by the dominant market-cap-weighting of FAAMG. So, is there anything wrong with this dominance of a few juggernauts, while the likes of JC Penney (JCP ) continue to get creamed in the marketplace? Perhaps not in the short term, but their supreme dominance certainly discourages new entrants, and there is a growing risk of a populist and protectionist-leaning movement pushing for anti-monopolistic measures. Remember the 2001 anti-trust case brought against Microsoft (MSFT)?

2017 has been a year for Growth and Momentum over Value and Quality. But after the market pulled back in mid-August, its initial recovery rally seemed to suggest a budding rotation into neglected market segments, including mids and smalls, as well as factors like Value, Low-volatility, and Quality. But then the Momentum factor started to kick back into gear, and Friday’s mega-cap Tech rocket ride put Growth and Momentum back to the forefront. Still, I firmly believe that a broadening into other market segments is required if this bull market is going to remain sustainable.

I have talked in previous articles about equity valuations being elevated but justified, given the climate of structurally low-interest rates, stable global economic growth, and solid (and improving) corporate earnings trends here at home. When you consider that the implied earnings yield of a 20x P/E ratio on the S&P 500 is 5%, stocks still look quite attractive compared to the 10-year Treasury yield at only 2.4%. Moreover, the dividend payout ratio for the S&P 500 (based on trailing operating earnings) is a fairly safe 40%. And Sabrient can find lots of compelling valuations in individual stocks flying under the radar, sporting attractive forward P/Es with strong expected year-over-year growth.

The CBOE Market Volatility Index (VIX), aka fear gauge, closed October at 10.18. Although investors are still wary that there hasn’t been a significant stock market correction since February 2016, complacency reigns supreme. Even during August’s brief spike in volatility, VIX peaked at 17.28 and has not approached the 20 panic level in a long time. Last Wednesday’s brief market pullback only pushed VIX to 13.20. But it is comforting to see the broadening participation across market segments, and in fact, low volatility is the historical norm when economic growth is stable. Performance dispersion among sectors has been higher, while correlations have been relatively low, which should continue to put downward pressure on the VIX .

And absent a systemic financial threat, low volatility should persist. Can another flash crash occur? Well, nothing is impossible, especially with all the algorithmic trading going on. But in the wake of 1987’s Black Monday crash (when S&P 500 fell 23%), the SEC instituted “circuit breakers” to halt trading at three separate levels of selloffs (7%, 13%, and 20%), and President Reagan established what today is euphemistically called the Plunge Protection Team (PPT) to stabilize markets in a crisis. And in the middle of the 2008-9 Financial Crisis, mark-to-market accounting requirement was changed, allowing for the use of orderly-market pricing rather than in forced-liquidation pricing. These measures lessen the risks of a crash significantly.

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Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into ...

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