• The technology sector peaked on September 2nd and declined in September.
  • Buffett and Shiller indicators show today’s market valuations are extreme.
  • Trump’s COVID-19 diagnosis and the election are adding to market risk.
  • The ratio of growth equities to value equities is at a cyclical turning point.
  • Sell FAANG stocks, QQQ, and the S&P 500 (SPY).
Last month, two generational trends reversed. First, Federal Reserve policy shifted from inflation fighting at all cost to tolerating above normal inflation. Materials, metals, mining, cyclical inflationary stocks, and interest rates have started to lift. Second, technology stocks peaked on September 2nd, which mirrors the March 24th, 2000 peak – a gap opening following a multiyear rise, extreme valuations, and classic market euphoria. These two powerful trend reversals have created sea change risks in the market that could significantly impact returns in the long term. Technology stock holdings and the S&P 500 should continue to be reduced and reallocated to inflationary cyclicals, value stocks, and cash.

Near term risks have also increased with the President’s COVID-19 diagnosis. While many investment professionals dismiss stock market risks associated with the Presidential election, we fear election consequences could have potentially large negative impacts on the stock market because of the market’s historically high valuations. One risk we fear is an undecided election, where historically high partisanship, violent extremism, uncertainty, and election-deciding legal cases could erode market confidence and faith in United States’ democratic institutions. This result will be exacerbated and cheered by adversarial nation states and anti-establishment extremists. Goldman Sachs has similar fears according to FINSUM “Goldman Sachs is stressed about the election. In particular, they are concerned about what a contested outcome could mean for stock prices….   Goldman is making it abundantly clear that they think most paths for the market lead lower—likely until the end of the year. With Trump now having COVID, that makes uncertainty even higher.

Market Risks are Greatest when Valuations are Extreme:

The “Buffett Indicator” (charted below) of Russell 5000 to GDP (Gross Domestic Product) shows the US equity market valuation to be at historically high levels.

The Tech Top Catalyst:

FAANG and QQQ momentum reversed in September. This month’s 5 yr chart of NASDAQ 100 (QQQ), Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOGL) show the group’s parabolic rise is breaking down.
Last month’s letter, when we called the 2020 tech top, showed the same 5 yr chart (below) of NASDAQ 100 (QQQ), Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOGL) at their peak.
The FAANG stocks and NASDAQ 100 (QQQ) declined from September 2 through October 2: NFLX 5.22%, AMZN 7.94%, QQQ 8.54%, FB 9.8%, GOOGL 10.1%, and AAPL 13%. The chart below shows their performance over the last 30 days.

Tech Earnings Momentum Rose With COVID-19:

Following the March COVID-19 market crash, technology stocks were crushed along with the whole equity market. In the months following the initial crash, lockdown beneficiaries like Amazon and Netflix experienced an earnings acceleration as people changed their spending habits due to the lockdown. The FAANG stocks and the QQQ all rose to higher highs in the second and third quarters as COVID-19 economic shutdowns proved accretive to these companies’ prospects. The chart below shows the QQQ index rose from 170.04 in March to 302.76 on September 2, a 78% five month rise.
The ratio of the stock market to the US economy’s gross domestic product has expanded from about 20% to 185% a nine times multiple expansion since the early 1980s.

Tech Earnings Momentum will Decline:

When the third quarter earnings report in the coming weeks for these tech darlings, their irrational exuberance will fade as their stock prices suffer from decelerating earnings momentum. Once that momentum begins to fade, the extraordinary multiples held by these companies will start to contract. While technology valuations may not be as expensive as they were during the 2000 tech peak, these high valuations will contract with earnings deceleration, rising rates, and a shift to cyclical/value investments.

Federal Reserve Inflation Catalyst:

The Fed’s new policy will allow for inflation to run higher, helping inflationary cyclical and value stocks and hurting technology stocks, the S&P 500, and bonds. The Fed’s stated intent will allow for greater pricing power in inflationary and commodity stocks. This policy will improve inflation and value stock earnings prospects. Technology stocks, which are long duration assets, will feel the weight of rising rates as their future earnings will be discounted more aggressively in the future.

Interest rates have been declining for decades. Consequently, few investors have any memory for the types of investments which work best in an inflationary or rising rate environment.

The data box below shows that in September 1981, when the 10-year US Treasury yield was 15.32%, the Cyclically Adjusted Price Earnings (“CAPE”) on the S&P 500 index was 7.58. The CAPE has now risen to 30.63. This CAPE multiple expansion of 4.04 times means that the market today is willing to pay 4 times for the same dollar of earnings it did in 1981. The CAPE multiple expansion is comparable to the Buffett Indicator multiple expansion of 4.39 times from the early 1980s until today. If interest rates rise because of this new Fed policy, the S&P 500, and technology stocks could decline even without an earnings contraction.

A Secular Shift to Inflationary Assets:

With rising rates and inflation, cyclical/value will begin to outperform growth stocks. The chart below of the ratio of world value stocks to growth stocks is currently at an historic and cyclical low.
Source: KCI Research, Ltd.
Commodities are also inflation and rising rate beneficiaries. Fortunes were made in commodities from the 2000 tech bubble until 2008 peak, and the market today is at similar extremes. Oil’s price action is emblematic of both inflation and commodity price behavior over the last 60 years. In the late 1990s oil rallied from below $20/bl to $137/bl in 2008. This spring, oil traded to negative $37/bl due to technical factors, the OPEC dispute, and the COVID-19 crash. While oil’s ugly environmental reputation assures a massive rally is unlikely, other commodities could prove valuable and a prudent investment alternative to stocks and bonds.

The chart below shows oil’s price history over the last 60 years.

The chart below shows the cycles of inflation and deflation since the early 1970s. When inflation increases as reflected below with the Producer Price Index (“PPI”), the S&P 500 declines. When inflation declines, the S&P 500 appreciates. The new Fed policy is more tolerant of inflation and this new cycle appears to be more inflationary.

Better Safe Than Sorry:

The market is at historically high valuations with rising risks. The stock market has enjoyed a tech bull market as extreme as the 2000 tech bubble. The Federal Reserve’s more liberal view on inflation should lead to higher inflation and interest rates. Our market cycle research and experience assert that technology stocks peaked on September 2nd and technology holdings should be reduced. Further, the Federal Reserve has removed the lid on inflation. Inflation should lead to higher interest rates and lower stock market prices and valuations in the days, weeks, months, and years ahead. S&P 500 holdings should also be reduced. It is no surprise that the S&P 500 ETF (SPY) and FAANG stocks are the most widely held of all publicly traded equities.

We advise reallocating away from recent years’ equity winners and into value stocks, emerging market stocks, commodity stocks, commodities, precious metals, cash, and floating rate bonds. We also advise selling long term bonds like the 10 year US Treasury which currently yields 0.7%, a terrible and historically low yield.

If our assertions are correct regarding inflation, interest rates, and the technology sector, portfolio strategy will need to be fundamentally revised. It is better to be safe than sorry.