Technology: With Great (Growth) Power Comes Great (Multiple) Responsibility

Summary

• Are you familiar with the "Aggression Scale?" Instead of the common classifications, it's measuring sectors based on their volatility, cyclicality, and growth.
• Three sectors currently are making it to the top of the "Aggression Scale." Technology is only one of those.
• Can we be overweight all three sectors? Technically, we can. However, as per our portfolio and risk management practices, we don't want to. We also don't need to.
• Investing is a relative game, and when trends change - so must we. But first, we need to identify the trends and determine whether changes are "for real."
• We're underweight tech stock. There you go, we've said it. But there's more to this. Much more. Keep reading and see for yourself.
• Looking for a helping hand in the market? Members of Wheel of Fortune get exclusive ideas and guidance to navigate any climate. Learn More »

Photo by Gareth Cattermole/Getty Images Entertainment via Getty Images

Turning Aggressive

So far, we have covered eight out of the 11 S&P 500 sectors along this series that we're running as part of Wheel of Fortune's fourth anniversary.

Each macro article, focusing on a specific sector, is being followed by a micro article, focusing on our top pick for (at least) the rest of 2021.

Sector/Macro (TFT articles)	Top Pick/Micro (Nick articles)
Energy	MPLX LP
Financials	China Life Insurance
Utilities	Vistra Corp.
Industrials	Teekay LNG Partners
Healthcare	Bristol-Myers Squibb
Communications	ViacomCBS
Consumer Discretionary	Alibaba
Consumer Staples	None
Real Estate	None

Click to enlarge

Only two now left.

Two sectors for us to cover (Tech and Materials) as part of this series, and two days for you to take advantage of our fourth-year anniversary.

What's so special about these two sectors (for us)?

1) For good and for bad, they are the most interesting sectors right now.

2) Aside of Energy, they're the two sectors that get the highest score in our "aggression scale" (more details below).

3) They're playing very different roles in our portfolio and risk management.

When people we're engaged with (in and out of Seeking Alpha) ask me "what's the edge?... what's the added value?," my answer is: You'll hear us talking about risk way more than about return.

Everybody tells you how important risk management is for them before you join, and once you do - it's almost entirely about returns. We, on the other hand, only start accelerating the "risk talks" once you join, and it only gets "worse" as time goes by...

We run the "Wheel," but we don't try to invent the wheel.

Instead, we simply try to spin it a bit differently than others, with way more focus on risk.

The two sectors we're left with to cover as part of this series, Tech and Materials, are clear, live, examples how our "Wheel" spins differently.

They're the greatest "show" we can currently present you with.

The "Aggression Scale"

Based on most classifications, including that of Morningstar (see below), the 11 sectors are split into three groups: Cyclical, Defensive, and Sensitive.

(Source)

We prefer a bit different classification - "Aggression Scale."

In order to determine how aggressive a sector is, we use the sub-categories:

• Volatility

• Cyclicality

• Growth

Each sector, within each sub-category, gets a score: 1 = low, 2 = medium, 3 = high.

The higher the total score - the higher the level of aggression.

A score of 7-9 suggests a (relatively) high level of aggression.

A score of 3-5 suggests a (relatively) low level of aggression.

A score of 6 means that the sector is sitting on the borderline.

Based on that "Aggression Scale," here's how we look at the various sectors (right now):

Sector	Volatility	Cyclicality	Growth	Total
Energy	3	3	2	8
Materials	3	3	2	8
Industrials	2	3	2	7
Utilities	1	1	1	3
Healthcare	1	1	2	4
Financials	2	2	2	6
Consumer Discretionary	2	2	3	7
Consumer Staples	1	1	1	3
Information Technology	3	2	3	8
Communication Services	2	2	1	5
Real Estate	2	2	1	5

Click to enlarge

The most aggressive sectors (total score = 8) are: Energy, Materials, and Technology.

Then, we have two sectors that are less, yet still, aggressive (total score = 7): Industrials, Consumer Discretionary.

Financials is the only sector which sits on the borderline (total score = 6).

Then, we have two sectors that (in our view, of course) are more defensive than aggressive (total score = 5): Communication Services, Real Estate.

At the bottom, we have the classic defensive sectors. Yet, we Utilities and Consumer Staples (total score = 3) to be more defensive that Healthcare (total score = 4).

Why is this important?

Aggression level is a good indication of the associated risk and potential return. A high score means that these are the sectors we expect to be most risky and to potentially deliver the highest returns.

But there's more to it than just risk and reward.

As part of our risk management, we often wish to be underweight and overweight (at the same time) two sectors that share the same aggression profile. In other words, the "aggression scale" allows us to better align sectors with one another, as part of our risk mitigation process.

Sure, if one wishes to be super-aggressive and builds a portfolio which only contains the most aggressive sectors - that's fine. Be our guest.

We, however, operate differently, and we always try to maintain balance within the portfolio we're managing. As such, you won't find us betting big on Energy, Materials, and Technology - all at the same time.

Something's Gotta Give

We started this series with Energy (total "aggression score" = 8) and you already know that we're overweight this sector.

We're now sharing with you that we're also overweight Materials. As a matter of fact, Materials is the sector we're more overweight than any other sector!

If "Something's Gotta Give" and if among the most aggressive sectors we're overweight two out of the three, guess which sector we're underweight?

Now, before you jump and shout how can anyone be underweight tech, we wish to remind you that our strategy is different. This is neither the time nor the place to touch upon this fully, but the bottom line is that we use tech as a hedge to counter the high exposure to other aggressive sectors. It doesn't mean that we're anti tech.

Think of it this way:

• Over the past seven months, both Energy and Materials have outperformed Tech.

• Let's assume that you're only investing in these three aggressive sectors.

• Now, do the math yourself: Instead of spreading your money across these sectors the same way the benchmark does, you've allocated more to the sectors that have outperformed, and less to the sector that has underperformed.

Not such a bad deal, isn't it?

If that's not enough, let's not forget that (long-term) yields already are on the rise, and with the way growth, inflation, and employment look like - (short-term) rates may follow through, sooner than the Fed currently communicates.

When the discounted rate rises, cash flows of higher growth companies are getting hit harder. That's not an opinion, that's math.

Two months ago, we assigned an "Underweight" rating to the sector, stating the following:

Sure, tech stocks are going to post double-digit growth on both top and bottom lines, but the growth rates are unlikely to be "out of ordinary," and this is why we believe that growth rates would be "in line" rather than "extraordinary."

Of course, you may claim that an "in line" growth in tech is better/higher than an "extraordinary" growth for the entire market - we accept that - but we look at growth on both absolute and relative basis, against both the market and the sector itself.

Having that in mind, we believe that 2021 is likely to see tech shining less compared to both the market as a whole, as well as to tech itself in 2020.

Add to that the extremely high valuation (to begin with) of the sector, as well as the rising yields - clearly a negative factor - and you end up with a setup that isn't ideal for tech stocks, to say the least.

Now, let's see what "pros" and "cons" tech stocks currently hold.

Risk vs Reward

Pro: Largest upside potential (+14%) among all sectors.

Con: Second-largest 30-day rolling volatility (+20%) among all sectors.

Over the past 12 years, tech investors have been compensated very handsomely for the risk they took. For many, tech stocks delivering phenomenal returns is a default, a natural part of investing.

Well, it's true that this has been the case since 2009. We aren't even suggesting that this may not be true going forward. However, we are old enough to remember different times.

Between 1968 to 2009, inclusive, tech stocks have been the worst-possible investment; a real nightmare...

If you invested in tech stocks during these 42 years (!), you took the highest risk and you've been paid the lowest reward.

Higher Volatility + Lower Return = Very Bad Investment.

Earnings Growth

Pro: EPS growth, past

Technology is the second-best sector in terms of EPS growth over the last five years. Only Consumer Discretionary comes ahead.

Source: Finviz

Con: EPS growth, future.

In both 2021 and 2022, tech stocks are expected to see nice (double-digit) earnings growth rate. Nonetheless, in both years, tech stocks are expected to see earnings growth which is lower than the S&P 500 average.

Revenue Growth

Pro: Revenue growth, past.

Technology is the fourth-best sector in terms of revenue growth over the last five years. Only Communications, Consumer Discretionary, and Healthcare come ahead.

Source: Finviz

Con: Revenue growth, future

While in 2021, tech stocks are expected to maintain their past five-year average revenue growth of ~12%, in 2022, the expected growth is only ~7%.

More alarming than the decline itself is the threat of the sector posting a single-digit growth.

Valuation and Dividend Yield

Con: Second-worst forward P/E, way above historical norm.

Con: Second-worst P/S.

Source: Finviz

Con: Dividend yield.

Tech stocks are paying less than 1%, only Communication Services and Consumer Discretionary pay less than Technology.

Source: Finviz

Performance

When was the last time tech stocks have been lagging that much?

Source: Finviz

Even when we measure the performance since the market bottom on March 23, 2020 - Technology is only ranked 6th (total return).

Rotation

In case that you've missed that, over the past eight months, value has outperformed growth on each and every level/index you may wish to measure it.

Index	Value ETFs	Growth ETFs	Difference*
S&P 500	Value ETF (IVE) +29.44%	Growth ETF (IVW) +13.28%	+16.16%
Russell 1000	Value ETF (IWD) +32.04%	Growth ETF (IWF) +12.37%	+19.67%
Russell 2000	Value ETF (IWN) +58.43%	Growth ETF (IWO) +32.15%	+26.28%
MSCI USA	Value Factor ETF (VLUE) +40.84%	Momentum Factor ETF (MTUM) +9.60%	+31.24%

Click to enlarge

*In favor of Value over Growth, since Aug. 31, 2020.

Data by YCharts

Not only has growth/value, measured by IWF/IWD in the below chart, is way off its highs, but as you can see - the level that has been providing support (for growth) over the past year (green arrows) is now turning (again) into a resistance.

The writing is both on the Wall (Street) as well as on the charts.

And if that's not enough, there are more signs of softness, let alone real weakness.

Signs of Weakness

Recent IPOs - the hottest thing on Wall Street two months ago - are in a freefall.

Semis are also losing steam since the "shortage of chips" chatter has emerged.

Source: Bespoke Investment Group

Semis and transportation stocks were leading the charge since March 2020, with the former outperforming the latter since the US election and until about a month ago.

Now, it's the other way round, with Industrials (transports) outperforming Technology (semis).

We are reiterating our cautious outlook and continue to expect the S&P 500 to test ~3,950. Semiconductors, which rallied 165% off the March 2020 lows, are now threatening multi-year relative trend breaks.

Image: Jonathan Krinsky @jkrinskypga

Bottom Line

This market isn't cheap, to say the least.

At 22.0x, the S&P 500 forward P/E is 23% more expensive than the five-year average (at 17.9x) and 38% more expensive than the 10-year average (at 16.0x).

And if the market valuation isn't attractive, what can we say about Technology, one of the two most expensive sectors within the S&P 500?

The Nasdaq has now trailed the S&P 500 over six consecutive trading days, cementing a very poor performance by tech stocks over the past month.

Meanwhile, while tech stocks are underperforming, Materials and Energy keep outperforming.

If you ask why are we underweight tech stocks - we hope that this article has provided you with some good answers.

The more interesting question is not why are we underweight tech stocks, but why are we underweight tech stocks while being overweight Materials?

Take a look at the below chart, presenting the XLB/XLK ratio.

Not only we're seeing a breakout from a 14-month base (flat blue line), but this is another live evidence that the value investing has raised its head.

(Source)

Ten sectors behind us, one more to go: Materials.

Stay tuned!

Analyst’s Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.