With concerns over the fiscal cliff mounting, stocks traded lower for most of last week, posting modest gains on Friday and a stronger rally on Monday. Still, last week was the fourth in a row that stocks fell, marking the longest losing streak since the summer of 2011. It underscores my argument that until the fiscal cliff is resolved, markets will move based on news related to the cliff.
In light of the ongoing concerns about the cliff and recent market moves that have changed valuations, I favor two portfolio moves: reducing exposure to US industrials, while overweighting global technology.
First, some background. While there is definitively a path to compromise on the fiscal cliff, the problem in Washington continues to be that neither party is moving far from its initial position. The Republican leadership has given some ground by entertaining the notion of higher tax revenue without changing marginal tax rates. But with Congress on holiday next week, we don’t expect to see much progress until early December. That means volatility is likely to remain elevated until a path to a resolution starts to emerge.
Another danger for the markets is that continued uncertainty risks creating a dangerous feedback loop. As stocks drop, this typically undermines consumer confidence. In addition, as negotiations over the cliff drag on, businesses are less likely to commit to new hiring or investment. This combination raises the risk of slower growth in Q4 and potentially Q1, even if the fiscal cliff is ultimately avoided.
Given this environment, I am no longer advocating an overweight position to US industrials, and I would suggest that investors consider a more neutral, or benchmark, stance on this sector. At the same time, I would now suggest overweighting technology companies.
As of the middle of last week, US industrials had narrowly outperformed the US market and had beaten global industrial stocks by roughly 350 basis points. But while the stocks have done relatively well, earnings growth has been a bit disappointing. As a result, the sector has now become a bit expensive, trading at 2.5x book value and roughly 14x forward earnings, both premiums to the broader market. Industrials are also trading at a significant premium to their own history, making them look even more expensive when compared with other cyclical sectors like energy or technology.
Meanwhile, since the start of Q4, technology has been trailing the broader market. Global tech indices are down 7.9% with US tech down 10.8%. As a result, as of the end of October, global tech was trading at a 10% discount to its own 5-year history based on its price-to-book ratio and 18% discount based on forward earnings. However, while global technology companies as defined by the Global Industry Classification System have gotten significantly cheaper, they are still highly profitable with a return on equity of 27%.
Since technology has long been viewed as a high-risk sector, some investors will question the wisdom of increasing exposure with the fiscal cliff looming. However, what is interesting to note is that over the last decade, technology stocks have become much less volatile. In fact, financial stocks are now the global market’s most volatile sector.
Thus, we’re comfortable reducing exposure to US industrials while overweighting technology because this should allow investors to maintain their cyclical exposure with a cheaper sector, without raising the overall volatility of their equity exposure.