US rotation still has momentum

The U.S. stock market’s rotation away from the broad factor of ‘growth’ in favour of a return to ‘value’-linked shares has proven itself to be alive and well this week. This has revived investor wariness that the drivers of the U.S. stock market gains for the last few years might have over-extended themselves, possibly with consequences that go beyond a ‘normal’ correction.

We disagree. Furthermore, we see the line of least resistance for the year ahead in U.S. and global markets as favouring an extension of trends seen in 2017. At present, broad equity market themes can be explained by the tendency of major investors to use the latter part of the year for position squaring, window dressing, rebalancing and so on. With well-defined buying patterns in the holiday weeks, this time can also be useful for momentum and volatility-seeking large speculators, whose presence will also be discernible. Given that the S&P 500’s Information Technology Index has not only underperformed the broader index over the last month, falling 2.6% versus the S&P 500’s 2% rise, the prevailing preferences amongst investors in the largest U.S. shares is clear.

We note that the current fall from favour of technology focused sectors is reminiscent of similar events during during June. Then, shares of large U.S. Internet, semiconductor and others in innovative sectors also saw a distinct sell-off. In other words, regardless of the likely length or depth of the current instance of ‘value’ taking over leadership from ‘growth’,  its re-emergence may not be fleeting. Even so, with S&P Info Tech’s lead this year an unassailable 33.5% compared to the overall market’s 18% gain, and scant reason, from our reckoning, for investors to reject the growth theme for the long-term, momentum effects that typically take over in the final weeks of the year are highly likely to home in on growth proxies like the Nasdaq 100 index and its key outperformers.

One development over the last few days read as having contributed to the decline of U.S.-listed technology industry shares is an amendment to the tax bill that is currently wending its way through The Congress. The corporate Alternative Minimum Tax limits the scope of tax credits—meant to encourage research and development—for tax reduction. There are signs of a compromise by Senate Republicans as the bill, currently in conference committee stage, moves towards law. But even if the amendment is inked, it is already clear that R&D  tax regime is strongly tilted towards smaller emergent firms rather than established corporations. The latter have most eligibility via ‘qualifiying’ R&D expenses, to a maximum of 9.1%. That rate would represent a small fraction of revenue for the large U.S. technology names that have driven their stock market for almost half a decade.

From a technical basis, it is interesting that a ratio of the S&P 500’s most representative ETFs of the value/growth continuum has breached its cleanest rising trend line in place since December 2016. This is no guarantee that the components of the growth ETF are set for a sustained correction. However, the appearance of the largest fracture in their advance for about a year is another reason we expect the current decline of the Nasdaq index and related factors to continue to be seized upon in the near term. The ratio found its best support during the summer’s decline just under 1.30, compared to 1.33 at the time of writing. However, so long as retracements of key related indices remain as normative as they have been, we expect ‘potential correction’ to again turn out to be tech sector consolidation. (Note that the Nasdaq’s bounce at the time of writing follows a 61.8% retracement of its rise from mid-November lows around 6667).

In conclusion, we continue to find it implausible that recent fractures amongst U.S. technology stock markets are the beginning of a ‘great correction’, though it may be somewhat early to take any quick rebound at face value just yet.