Gordon Gekko was right: Stocks are now a zero-sum game

David Nelson
David Nelson

Somebody wins, somebody loses

By David Nelson, CFA

We’ve hit the point of no return for 2017. It’s probably a good spot to check our compass and make sure we have enough fuel to complete the journey. With the exception of a few bumps along the way, the broad indices have been relatively benign. However, trading beneath the surface has been ferocious, as investors scrambled from one sector to the next with each hiccup in the news cycle. Today’s half-day, which begins the third quarter, is no exception.

The tech sector was killing it this year through May. (Source: Bloomberg)

Reversion to the mean is a powerful force and we’ve seen that play out several times across a number of sectors. Late last year financials (XLF)—then, and still our biggest overweight—exploded higher following the election. As 2017 and the year unfolded, it became clear that the agenda wasn’t going to unfold smoothly, as financials and other parts of the reflation trade stalled.

June – Reversion to the mean

Picking up the baton was tech (XLK) along with other secular growth favorites. FANG, FAAMG and just about every other acronym based growth basket soared with a vengeance. Early in June, the ninth to be specific, we had a huge intraday reversal in all of your favorite mega cap tech stocks.

Source: Diego Olivares

Apple (AAPL), Amazon (AMZN), Google (GOOGL, GOOG), Microsoft (MSFT), Facebook (FB)—it didn’t matter. They were all for sale on seemingly little news. That’s how it rolls in the world of robot, machine reading, algo trading. Sector swings and repositioning that used to take days, weeks or sometimes months to unfold can now be accomplished in just a few hours.

Wall Street’s Gordon Gekko was fond of calling the markets a “zero-sum game,” and on June 9, that’s just what it was. Tech’s losses became financials’ gain, and the reversion to the mean trade was underway once again.

There was massive sector rotation in June, as investors dumped tech stocks and poured into financials. (Source: Bloomberg)

After several days of recovery, the bloodletting continued following comments from Mr. “Whatever-it-takes Draghi,” hinting another central bank was at least moving closer to the exit. The fear of an end to easy money swept trading desks around the world.

Mario Draghi at the ECB talked up global long-term yields. (Source: Bloomberg)

The explosive move higher in German 10-year yields removed a heavy overhang for the US curve, where yields moved higher in concert with their European brothers. All of this fed into the reversion to the mean trade mentioned earlier, as traders rode into the second quarter sunset yelling “yippee-ki-yay.” When the dust settled on June, technology, arguably the most watched sector, closed lower on the month despite a staggering first half return.

As I write this on the first trading day of the new quarter (a half-day in the markets due to the Fourth of July holiday), the Dow Industrials (^DJI, DIA) made a new all-time intraday high, closing up 0.61%. The beaten-down energy (XLE) sector led the S&P 500 (^GSPC, SPY) higher (0.23%), as crude posted its eighth consecutive day of gains. Meanwhile, the Nasdaq Composite (^IXIC, QQQ) got hammered, closing down -0.49%, led by the semiconductors, with Nvidia (NVDA) one of the worst performers at -3.78%. Par for the course.

I doubt the business models have materially changed for some of the street’s favorite names (e.g., Google, Facebook, Amazon and others). If forced to make a prediction, I’d say they’ll be higher a year from now—but from what level is the challenge.

Earnings—now what?

Here we are once again with another set of earnings reports on the horizon. The headline numbers will attempt to validate the second quarter price performance, but it will be the guidance that sets the stage for Q3 returns.

Earnings expectations are starting to slip. (Source: Bloomberg)

While some, like Goldman’s David Kostin, are raising their estimate for this year and next, he is close to consensus. Maybe a more telling look is the Bloomberg blended forward estimates, which have started to slip.

Noise, or just analysts tweaking numbers? We’ll find out soon enough. Running quantitative models that focus on the fundamentals of individual stocks can often make life a little easier. Removing our biases and some of the subjectivity along with a rules-based approach provides discipline.

If the sector should be overweight, it will likely show up in the numbers, especially if you are a “Growth at a Reasonable Price,” or GARP investor. Currently, our sector overweights are financials (XLF), tech (XLK), industrials (XLI) and health care (XLV), with nothing in utilities (XLU) and very little in energy (XLE). Others are approximately market cap weighted.

I’ll be closely watching for any continued weakness in semiconductors (^SOX), which often act like a leading indicator for technology. This has been one of the hardest hit areas of tech recently, including today. While valuations are still very attractive, the price action is very “year 2000″—especially after it became apparent that there was some double ordering. I have no evidence to date, but the continued sell off following early morning gaps higher is worth noting.

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