Can the S&P 500 rally if Technology stocks don’t? Last week’s sloppy action in the group, capped by Friday’s selloff, make that the question of the moment. This isn’t only relevant to US investors, by the way. Chop up various all-world equity indices from MSCI and others and you will find US large cap Tech is the only reason global stocks are positive on the year.
The central problem here is simple math:
- The Tech sector is 26.2% of the S&P 500.
- Five names represent 15.5% of the index: Apple (4.0% weight), Microsoft (3.5%), Google/Alphabet (3.2%), Amazon (3.0%), and Facebook (1.8%).
- The same 5 names are 7.9% of the MSCI World Index, greater than the allocation for all Japanese equities (7.5%).
Any scenario where the S&P 500 continues its 2018 advance in the face of a decline in Tech shares is therefore something like those “Paths to victory” analyses you see during US presidential elections. If a candidate loses big states like California and New York, what other states must they win to prevail? It is difficult, but as we know from 2016 entirely possible.
As a simplifying assumption, let’s say Tech stocks decline 10% between now and year-end - what the financial press calls a “Correction”. This wouldn’t actually be enough to put Tech in the red for the year, but it would mean a mere 1.1% advance in 2018. After nearly a decade of dramatic outperformance, that would be enough for many to write the sector’s obituary.
Here’s how the S&P’s “Path to Victory” works in that scenario:
#1. To compensate for this decline, we would need 1:1 offsetting positive performance (or slightly better) from at least two of the following four sectors:
Health Care (14.3% weighting in the S&P)
Consumer Discretionary (12.6%)
In aggregate, these represent 50.6% of the S&P 500.
#2. Importantly, the rest of the S&P’s sectors (Energy, Materials, Real Estate, Telecomm, Staples and Utilities) have only a 23.2% aggregate weighting.Given their differing fundamentals, it seems unlikely they would work uniformly enough to offset a 10% Tech correction. In our election analogy, they are Hawaii and Rhode Island.
#3. Good news: growth investors will most likely flock to Health Care if Technology starts to falter. Some of this may already be underway: the group is +5.8% over the last month, beating Tech’s 4.7% advance. FactSet earnings estimate data also shows Health Care is cheaper than Tech on 12-month forward earnings (15.8x vs. 19.0x) and expected 2019 bottom line growth (9%) isn’t far off Tech’s expected pace (11%).
#4. Bad news: Consumer Discretionary isn’t likely to help. Some 29% of this sector is Amazon (23.9% weight) and Netflix (5.2%). The rest of the group would have to offset declines here, but since media M&A is in high gear (and these companies are +10% of the sector) that is plausible enough.
#5. That makes Financials and Industrials the make-or-break groups in our 10% Tech correction analysis, as long as you buy the notion Health Care will rally due to sector rotation. A few thoughts:
- Financials are working right now (+6.7% over the last month), thanks to a steepening yield curve and decent earnings. They are cheap to 12-month forward earnings (12.7x) and are one of the few sectors still below their 2007 highs. The group also has an outsized weighting in Value indices, likely winners of capital rotation in a Tech meltdown.
- Industrials aren’t especially cheap (16.5x forward earnings), but the group is still +6.5% over the last month and now even up on the year (0.5%). Trade tensions obviously still weigh on the sector, even with recent positive news on that count.
Summing up: there is a “Path to victory” for the S&P 500 if the index loses the Tech sector, and it runs straight through Financials and Industrials. The former needs the yield curve to steepen (something we think likely). The latter could really use some good news on the trade front (possible, if only because the president likely wants some wins to campaign with ahead of midterm elections).
A few caveats to round out the discussion:
- Our mental model here assumes a slow grind lower for Tech, not a violent decline. Given the sector’s heavy weighting, that would likely spur rapid money flows out of US stocks generally. There would be little chance, in other words, for offsetting capital rotations such as we outlined in this note.
- Our base case also assumes continued strength in the US economy as well as low sector correlations (something we’ve seen for much of the year, and highlighted in these notes).