Tuesday, January 13th, 2015

Strike Two for US Tech

Our first piece on the US Tech sector (Early Warning – 4th November 2014) made the point that it is the largest sector in the largest equity market in the world. What happens here matters to every equity investor in the world, even if they have no direct exposure. It is hard to put together a scenario in which the Tech sector underperforms the US index, and US equities significantly outperform other global markets and Treasuries.

To understand why we are so concerned, a little history is required. Before last October, there had been only four occasions in our US sector model when the Tech sector peaked at an Overweight of more than +80%. They were January 1997, January 1999, March 2000 and April 2012. With one exception, the Tech sector then fell 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, Tech 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.

In late October the Overweight on Technology fell below 80% having peaked at 89% in September. We regarded this as Strike One and it prompted us to write the first note, in which we said, “If the sector falls through its 52-week MAV we will take this as a signal that a major sell-off is on the way”. Two weeks ago the sector fell through this level and it continued to fall last week, which means that we have just had Strike Two.

Strike Three will come when we formally downgrade the sector from Overweight to Neutral. However by that time it is highly likely that other analysts will also be telling investors to reduce their exposure, in which case it will be difficult to sell a significant amount of stock without moving the price. The interval between Strike Two and Strike Three is typically eight to ten weeks, so investors do not have to do anything immediately. But unless we get a Tech bubble like 1999/2000 it is very likely that the sector weight recommended by our model will be trending down not up.

So far we have concentrated on the signal rather than the investment case, which is not really our speciality. We have two main concerns. The first is dollar strength which impacts at a number of levels. The Tech sector is the most exposed to non-US sales – over 50% is not uncommon – and translation effects could have a major impact on forward guidance, even if some of the exposure is hedged.

The other concern is that everyone who wants to own the sector already does, and that they are few, if any, marginal buyers. This would not matter if the investment landscape was the same as the summer of 2014, but it isn’t. Thanks to the fall in oil prices, everyone now wants to gain exposure to the US consumer, which leaves Tech looking a little old-fashioned. The absence of a reason to buy can quickly become a reason to sell.

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