In what we have taken to calling the Icarus market, former high-flyers crashed and burned. As the broader market recovers, this group has still not risen from their ash-heaps. The fire in high-flyers burned ground-hugging stocks as well. As wealth and fund managers on the wrong side of momentum bets faced client redemption request, they were forced to sell high-quality and fairly valued stocks. Is there risk of a broader conflagration that could burn down the bull market?
Our short answer is no, at least for now. Across Argus, analysts assessing the damage have noted that the worst selling remains concentrated in former momentum darlings, but that sector declines have widened. David Ritter, Director of Financial Services Research, noted that alternative asset managers have been hardest hit and that payment processing stocks normally trading above the fray (V, MA) are now also being pulled down. David Toung and John Eade, covering healthcare for Argus, have watched the excessive enthusiasm toward biotech turn into a panicked "run for the hills."
These two sectors have declined rapidly as the rout in former momentum darlings has dragged down whole swaths of the market. Healthcare was the best sector in 2013, and it carried that strength into 2014. In the first quarter of 2014, healthcare was the second-best sector, as its 5.6% gain (in the iShares Healthcare ETF (NYSEARCA:IXJ)) lagged only the 8.7% gain for Utilities. In the first few weeks of the second quarter, however, healthcare is down 4.9%, trimming its year to date gain to a feeble 0.5%. The iShares Financial Services ETF (NYSEARCA:IYG) was up 2.0% in Q1 2014; it is down 4.6% in Q2 2014 to date, resulting in a 2.7% year to date decline.
We decided to look at the momentum crash through the lens of a single sector, technology. In our view, the sector decline is narrow, even though a broad range of names have been swept down in the momentum crash. The selling, in our view, is not indicative of fundamental ill-health in the economy or in the technology sector. And, as we detail below, the worst of the decline may be behind.
Without recommending that investors wander beneath a sky-full of falling knives, we would be mindful that periods of greatest fear usually closely precede periods of greatest opportunity. Once the market normalizes, we recommend remaining selective in technology as in other sectors.
Technology's Role in the Crash in Momentum Stocks
Biotech appears to be the most publicized collapsing segment of late. But the technology sector has also played a leading role in the crash of high-flyers. The sector's highest-growth niches - the social media, internet retailing, internet services, cloud, and software-as-a-service - are well-represented in the downturn.
Twitter (NYSE:TWTR) is down 37% year to date (all prices are as of market close on 4/11/14) Amazon (NASDAQ:AMZN) is down 21%, and Facebook (NASDAQ:FB) is up 7% year to date, but down 19% from its all-time peak dating from 3/10/14. In the familiar pattern described above, hedge funds and mutual fund managers on the wrong ((long)) side of these momentum bets have raised cash with quality names, helping broadly drive down the sector. The Technology iShares ETF (NYSEARCA:IYW) was up 3.0% in the first quarter of 2014; but it fell 3.7% in the first two weeks of the second quarter, resulting in a 0.9% year to date decline.
What is the source of the sudden selling in technology stocks, and in stocks in general? There are several sources; as usual, the gestalt of a market meltdown is greater than it parts. The principal reason for the selling in momentum stocks is that it was overdue. In the broad year-end rally, everyone was making money; if you were in ground-hugging stocks, you may not have noticed how exceptionally well momentum names were doing. The year-end rally was so strong it carried into the first quarter in a classic case of adaptive expectations (i.e., fighting the last war).
Rallies that get ahead of themselves become fragile. Even as indexes close ever higher, the advance can become thin and weakly supported. Fragile advances require only a few triggering events to topple the whole edifice. These events were graciously supplied by Mr. Putin and Ms. Yellen, with an assist from China.
The geo-political sequence of Russia hosting the hugely successful Winter Olympics and then days later occupying Crimea was startling and awoke echoes of Cold War. The ongoing instability in the Ukraine and Russia's unmatched might on the ground in the region have prevented the market from digesting this event and moving on.
Fed Chairperson Janet Yellen made a rookie mistake, in our view, when she used the occasion of a speech before an obscure trade group to provide an explicit timeline for Fed policy, without the usual hedges and wiggle room. The Fed Chair, new to the job in 2014, stated that the Fed would continue to wind down or taper quantitative easing along the current time-line - which would result in the program ending in October. More surprising, she indicated that the Federal Reserve could being raising the Fed funds rate in mid-2015. While this was no less than what the market was anticipating, to hear it so clearly from the Fed Chair was disconcerting.
The Fed has been furiously back-tracking ever since, suggesting that the recovery remains sufficiently uncertain to know the exact timeline of Fed policy. Still, the damage has been done. The weakness in emerging economies has intensified, on fears that rising U.S. interest rates will push up global rates and ramp up the pressure on over-leveraged investments in growth economies.
China's stalling economy has technology sector-specific implications. China is an important manufacturing hub for technology goods; increasingly, the giant nation is also the most important end market for smart phones, tablets, PCs and other gear. China's leaders are still re-setting the economy to grow without reliance on a shadow banking system and a housing market dependent on speculation. The broad market has grown used to China's malaise. For technology investors, the potential for weakening Chinese demand for technology goods was one more reason to sell the market.
Is It 2000 All Over Again?
When the tech sector starts selling off, technology investors reflexively ask themselves: is this 2000 all over again? Again, the short answer (we're in a short-answer mood) is no. We base our answer on industry environment, growth, and valuation, all of which are better now than they were then.
By the late 1990s, the entire technology sector - servers, storage, and PCs in the hardware space, software and services on the solutions side - was rallying on a set of false promises around mobile telephony and "internet everywhere." In truth, the early mobile phones were terrible. The dream of broadband everywhere and internet ubiquity choked on the reality of dial-up modems. It would be years before the smart phone and internet availability caught up to the hype.
Today, too, the technology reality is being jostled by next-generation promises. But the pace of transformation this time is breath-taking. The elements of next-generation technologies - cloud, hardware and network virtualization, social networking, mobile broadband, analytics, big data, software-defined everything, and everything-as-a-service - are being implemented in real time, and in some cases even before open standards have been established.
The technology companies that were peddling promises in the 1990s are now delivering profitable solutions. The clearest evidence is in strong cash generation, which is supporting shareholder-friendly capital-allocation programs. The technology sector, which formerly treated dividends as a bad word, now offers a 1.6% average yield - closer than ever to the S&P 500's 2.0% current yield.
In 2000, the entire technology segment was hugely overpriced. Stocks traded at double-digit price/sales ratios, and P/Es were stratospheric. We use the Nasdaq as a proxy for tech stocks, given Nasdaq's heavy weighting in the technology sector. The price-earnings multiple on the Nasdaq was close to 200-times at year-end 1999 (source: Morgan Stanley Dean Witter). Today, the technology sector is almost as cheap as the market. As of 4/11/14, the 12 months trailing P/E on the Nasdaq Composite was 20.7-times, compared with a P/E of 17.6-times for S&P 500 (source: Wall Street Journal).
Back in the day, sector investors bought and sold ideas; tangible signs of profitable growth, such as earnings, were a sign of stodginess and caution. Technology growth today is broad-based and sustainable. According to Argus Chief Investment Strategist Peter Canelo, Technology sector EPS is forecast to grow at a 17.6% rate for 2014 and at a 10.9% rate for 2015. Overall, Peter is looking for Technology sector earnings to grow at a 13.3% CAGR for 2013-18 - faster than our five-year forecast for broad market EPS growth of 11.8%.
The good growth coupled with the a reasonable P/E result in growth at a reasonable price (GARP, a favorite investment-manager metric). We focus on P/E divided by growth plus yield, or PEGY. The Technology sector has a PEGY ratio of 1.16, below the market's current 1.27 PEGY ratio. We have not calculated the Nasdaq's PEGY ratio for 2000, but you can guess it would be elevated.
How Will We Know it's Over?
Prior periods of Nasdaq underperformance not associated with a broad market crash and/or economic weakness have tended to last one to three months (source: Morgan Stanley). Of course, a backward look at the calendar has limited value in the current environment. But we are encouraged that the tech high-flyers that triggered the whole sell-off are re shedding gains from most frenzied momentum period and re-pricing to more attractive levels last seen in the October-December 2013 period.
Returning to some names we mentioned earlier, Facebook is back near its year-end 2013 price, Amazon has returned to price levels prevailing in the September-October 2013 time frame (we note that AMZN almost always has a post-Christmas selloff), and Twitter is back to its post-IPO levels from last November.
While we are not recommending that investors grab for the many falling knives in the technology universe, we do recommend being ready to buy the dip when the time is right. Dip-buying is an inexact science at best, but here are some of our guidelines.
We would keep an eye on Nasdaq volumes, which have risen during intense selling sessions. Lighter volumes on down days and rising volumes during recovery sessions could signal that selling ferocity is spent. Daily percentage declines in Nasdaq have been running at 1.5- or even 2-times the decline in the S&P 500; we will be encouraged once the Nasdaq trend resumes tracking the broad market trend. Finally, that last hour of trading is a good barometer of institutional attitude; and 3 PM to 4 PM has been deeply negative during the sell-off. When that last hour swings to positive, institutional money has gone from aggressively short to looking for long opportunities.
When markets normalizes, we recommend that investors remain selective. Recently, we pointed out that within Argus coverage, semiconductor companies were outperforming data center hardware companies. While value opportunities will present themselves in hardware from time to time, we would remain tuned in to the trends (cloud, social, mobile, analytics, etc.) that are reshaping the technology landscape around us.
The same holds true across our coverage universe. After last year's 30% broad market gain, and with even better performance in select areas of the market, investors have become more selective. The popular opinion appears to be that when the momentum crash is spent, high-flying and high-growth names will be shunned for the remainder of the year. We are not ready to buy that argument. Growth is growth; and, given the positive signs in the economy, we look for growth at these companies to continue.
Jim Kelleher, CFA, Argus Director of Research
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.