A good indignation brings out all one’s powers. – Ralph Waldo Emerson
The traditional cap-weighted S&P 500 has outperformed the equal-weight version of the index by nearly 10% year to date. Mega-cap growth names have led the charge, with the tech sector still up 24% despite the recent correction. It’s been a narrow rally, suggesting that there’s a lack of broad equity market strength that may not be visible on the surface.
Overall, the market’s 2020 gains can be attributed to just three sectors – tech, communication services, and consumer discretionary. All are growth-oriented and uniquely positioned to benefit in the COVID-19 economy. The growth of the online retail channel, along with the technological transformation needed to support the new remote and work-from-home economy, has driven the trend.
Current fund manager portfolio positioning is reflecting this as well.
Managers are overweighting these sectors and have only grown their positions since the bear market earlier this year.
There was a modest sentiment change mid-year when the economic recovery, thought to be progressing at a relatively robust pace, was showing signs of fading as a second COVID-19 wave picked up steam, and job growth slowed. There was a brief rotation out of growth and into areas, such as healthcare and consumer staples, two areas that figured to outperform during a slowing economy. By July, however, the defensive pivot had fizzled out, and investors returned to the “safety” of tech and large-caps.
A Defensive Tech Sector
The reputation of tech and communication services as rapid growth sectors is fair, but it’s behavior as a safe haven asset is a relatively new phenomenon. Investors have grown to trust the health and revenue growth of the mega-cap names, especially since they figure to still perform well even in an economic contraction.
Cyclicals have been a different story. A brief rally from that group over the past several weeks ended quickly when weaker-than-expected jobs data and the unlikelihood of another stimulus package from Congress killed momentum. As we’ve seen several times throughout the year, investors responded by buying up tech shares again despite rich valuations and broad-based equity selling.
The FANG stocks have clearly done very well not just in 2020, but pretty consistently since the financial crisis. In 2020, the FANG+ Index (which includes names, such as Alibaba (NYSE:BABA), Twitter (NYSE:TWTR), and Tesla (NASDAQ:TSLA) in addition to the FANG stocks) has outperformed the equal-weighted S&P 500 by more than 70%.
Tech remains firmly in the market’s good graces, but it’s time to concede the fact that a correction could be overdue. The sector trades at 29 times next year’s earnings, well above historical averages, and conditions unfavorable to another leg in the tech rally could be emerging.
Inflation risk remains relatively low on investors’ radars, but there’s a clear path to relatively quick spike under the right circumstances. Quantitative easing programs, record low interest rates, and robust consumer spending could force higher prices in the future, although it might take some time to get there. 10-year Treasury rates have hovered in a narrow range between 0.65% and 0.70%, showing little motivation to move much higher here. Breakeven rates on TIPS are back to pre-COVID-19 levels, but still not near the 2% mark required to even get the Fed’s attention at this point.
If, however, inflation data does show that fiscal stimulus and strong retail activity are lifting prices, it could be the catalyst that finally increases interest rates, pushes cyclicals, especially financials, into leadership and sends growth stocks swooning.
We saw earlier this month that investors are indeed willing to dump tech stocks under the right circumstances, in this case, evidence of a slowing economic recovery. If inflation rates, fueled by infinite levels of Fed support, start ticking up, it could trigger another leg lower for tech and other growth sectors.
Tech and growth are certainly overvalued, but it may take some time for conditions to become right for a deeper correction. Rising inflation could be the catalyst that triggers it, but that still may be months, if not years, off.
If we do see inflation rise, I expect increasing bond yields, a steeper yield curve, and a rotation away from risk assets. With the Fed committing to lenient fiscal policy for the next several years and showing a willingness to step in at the first sign of trouble, it remains to be seen if the central bank will let it come to that. The Fed’s new inflation averaging policy, which would let inflation run hot until it’s well north of 2% for an extended period, could, however, allow the above high inflation scenario to occur.
The September correction was a healthy consolidation for an overvalued sector, but a deeper move lower is still overdue.
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