Tuesday, November 4th, 2014

Early Warning

The following passage comes from an interview in the weekend edition of the Financial Times with Larry Page, the co-founder and CEO of Google. “Silicon Valley, still the epicentre of the tech business world, has become short-sighted, he says. While arguing that the Valley isn’t fundamentally “broken”, he agrees that it is overheated – “though how much that matters is a different issue.”

We quote at length because it agrees precisely with a signal that has been generated by our US sector model over the last six weeks. The Technology sector is currently rated as overweight and is #2 in our sector ranking, so there is nothing to be concerned about in the short term. However the sector is clearly past its best and an early warning is required given its size and importance. The recommended Overweight peaked at +89% on 12th September and has since fallen to +65%, which is just above its 52-week moving average (MAV) of +50%.

To understand why this is concerning, a little history is required. There are only four occasions since 1995 when the US Tech sector has peaked at an Overweight of more than +80%. They are January 1997, January 1999, March 2000 and April 2012. With one exception, the Tech sector has fallen dramatically to an Underweight of at least -65% within the next 12 months. The exception was January 1999, when the Overweight peaked in the high-80s, but did not materially fall through the 52-week MAV, which was then around 60%. This eventually led to the greatest bubble of them all, which burst in March 2000, when Tech went from an Overweight of +100% to an Underweight of -97% in March 2001.

In summary, Technology is not a sector which goes sideways once it has peaked relative to the rest of the US index. In the most recent sell-off, it went from +87% in April 2012 to -88% in April 2013. We often observe similar behaviour in other sectors which are subject to significant swings in sentiment. A good example is the US Small Cap sector, which peaked at +82% in October 2013. In January 2014, it fell through its 52-week MAV at a level of +47% and subsequently fell to an Underweight of -80%, from which it is only just beginning to recover. It wasn’t until Q1 that investors really began to notice the underperformance of Small Caps, though our model could clearly track the deterioration in risk-adjusted returns back to Q4.

We think the US Tech sector may be in a similar position now. If the sector falls through its 52-week MAV (which may well happen before the end of the year), we will take this as a signal that a major sell-off is on the way. Our sector models typically produce three or four of these signals a year and in that sense there is nothing special about this one. There are two reasons for the early warning. First, it is the largest sector in the largest equity market in the world. Every investor has some exposure to it. Second it is the living embodiment of American exceptionalism (the US is different). When the Tech sector falters so does the US equity market. Larry Page is correct when he says that the economic benefits of Tech won’t be erased if a few venture capitalists in Silicon Valley lose a lot of money. But if these losses crystallise in the public markets as well, then we are all in for a rough ride.

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