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Should Investors Buy The Tech Sector Pull-back Or Is It A Sign Of Worse To Come? Focus on Names With Rising Profit Margins Off Increasing Sales: Coming out of the weekend, financial markets are seeing a continuation of the sell-off in the tech sector following Friday’s one-day -2.47% decline in the sector benchmark Technology Select Sector SPDR ETF (XLK) with a -2.23% decline at the lows so far today. With the tech sector year-to-date (YTD) leading the broader S&P500 (+16.14% vs. +9.83%) with 5 stocks (AMZN, FB, GOOGL, MSFT, NFLX) accounting for one-third of the S&P500’s YTD gain, investors are wondering whether the tech sector decline marks a near-term top to the broader market and, if not, whether the current pull-back is a buying opportunity. Factors supporting both the tech sector and broader market gains have been the prospects for: 1) regulatory reform, 2) corporate tax rate reduction, 3) overseas profit repatriation, and 4) higher GDP growth. With the Trump Administration subject to increased Congressional scrutiny on possible obstruction of justice around investigations into Russian interference in the 2016 election, the opportunity to move forward with healthcare reform, tax code reform and a long-term infrastructure spending program is fast fading. Consequently, it is not surprising for diminished political prospects to cap the robust YTD advance.
Relative to the tech sector, note that FAANG stocks (i.e. AMZN, FB, GOOGL, MSFT, NFLX) have become a crowded trade and as a result of their strong performance investor portfolios are now overweight relative to other stocks & sectors. As such, normal portfolio management to achieve and maintain diversification would result in the overweight stocks being sold. The long-time Wall Street adage “no one ever got fired for taking a profit” has been unfolding as both the tech sector and the S&P500 have sold off from their intraday 52-week highs reached on Friday (Tech -3.3%, S&P500 -0.8%). Meanwhile, concerns have been raised that indicators such as household wealth and overall indebtedness have reached new highs, a development preceding past economic downturns. On this news, investors may be inclined to realize gains and adopt a less aggressive investment posture. However, note that 2Q17 earnings season will go into full swing within the next 4 weeks and investors may decide to use the pull-back as an opportunity to position portfolios for the upcoming results.
To that end, the table below shows the current 2Q17 growth forecast for sales and earnings for tech sector leaders along with the percentage decline of their shares from their respective 52-week highs and the P/E/G (price/earnings/growth rate) ratio contrasting the current 2017 P/E ratio with the EPS growth rate over the 2016-2018 timeframe. With possible concerns around economic growth, it is important investors consider those names where profit margins are expanding (i.e. EPS growth greater than sales growth) over names where profit margins are under pressure or where EPS are seeing outright declines. When faced with uncertainty, selectivity is critical to preserving capital and, along with it, performance.