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The “Pick Your Poison” Market

Courtesy of Nick Colas of DataTrek Research

Sometimes bad news defines stock prices more than good, so today we outline the overarching bear case for each major US industry sector. Despite all the negative headlines, the case for Tech isn’t as bad as you think. And Financials… Aside from still low long rates, not much bad there either.

Like many colorful English-language phrases, “Pick your poison” started in a tavern somewhere. Poison was slang for liquor, so bar keeper queries like “What’s your poison, mister?” were common enough. Add a little alliteration for zest, and you get the finished product.

It is also a very useful paradigm for thinking through US equity sectors allocations. Such is the squirrely nature of stock markets lately that we think investors have shifted their thinking from “Where’s the best upside?” to “Which sector’s poison is the least likely to kill my portfolio?”

At first blush this may seem like a simple observation, but it has a few useful offshoots:

  • First, the sector with the weakest poison will tend to outperform in a down market. As stock prices continue to churn (and they will), less noxious groups will see incremental money flows and plenty of buzz for their defensive attributes. You just have to pick the sectors whose stories will seem the “least bad” to other investors in 30-180 days, depending on your holding period.
  • Second, by explicitly considering just the downside case for a group we can assess what amount of bad news might prove lethal. “The dose makes the poison” is a millenniums-old saying, and it applies here. Every investment has its yin and yang, and prices move dramatically only when they fall out of balance.

Running through the various major sectors of the S&P 500 and their respective poisons, we get this:

Technology Poisons:

  • Regulatory risk. The problem here is one of dosage. Super cap tech stocks have the lightest ratio of regulation to market capitalization of any sector in modern history. Even small amounts of lawmaking will seem dramatic.
  • But ultimately what draws margin-killing regulation is 1) public health and 2) public wealth. Tech, broadly defined, is far enough away from those two factors to limit regulation’s ability to stymie its growth. Yes, self-driving cars touch on #1 – they will have a tougher road. But software, social networks, and hardware avoid breaching those criteria.
  • Weak Corporate Governance. Founder-controlled companies have been socially unresponsive entities since Henry Ford tried to bust the UAW in the 1930s, and at least his company was still private at the time. Facebook’s current challenges are a reminder that corporate boards can do very little to force managerial change when the person at the head of the table owns more than half the votes.
  • Higher Interest Rates/Valuation. Rising interest rates are typically kryptonite to richly valued companies. That’s just the math of a DCF model, and a clear problem for Tech if rates spike suddenly.

Our take: we remain positive on Technology, even if it is no longer an easy trade. None of these poisons are enough to kill the patient. Make them sick, yes… We’ve seen that. But none are deadly. Of the three, rates worry us the most since there’s no getting around the math. Still, the offset is a hopefully stronger global economy in a rising rate environment.

Industrials/Transports and Materials Poisons

  • Trade Policy. This lethality of this poison comes down, again, to dosage. If you believe (as we do) that the current tariff debate is political theater, then their unhealthy effects on these sectors’ stock prices will be temporary. If you believe the world is cycling into an all out trade war, then this group is done for a while. And so are equities generally.
  • Labor Costs. This is relevant to many individual companies in these sectors since they still tend to carry large employment rolls. At the same time, rising wages also helps spur consumer demand and therefore provide a partial offset. On top of that, direct labor costs are seldom more than 30% of an industrial company’s cost structure.

Our take: the current trade dust-up may be more symbolic than real, but these groups will bear the brunt of market unease on the topic. To overweight the group is to rely on markets seeing through the headlines and not get caught up in the hype. The market’s YTD record on that point is mixed, at best. Without the benefit of an infrastructure bill to bolster investor confidence, this group feels like an even-weight or even an underweight.

Energy Poisons

  • Commodity prices. The Energy sector is one of the worst performing groups YTD, despite the fact that WTI is up 5.6% in 2018. That tells us equity investors don’t trust the rally in oil prices.

Our take: we really want to like this group, if only because the “Poison” seems so innocuous. Energy has a long history of decoupling from commodity fundamentals, only to rejoin them suddenly. FactSet shows the sector having the best earnings comps for Q1 of any industry group. That makes this group an even weight, or better if one has the stomach to own a distinct market laggard.

Health Care Poisons

  • Amazon/Berkshire/JP Morgan. The chilling effect on the Health Care group from this trio announcing a JV in the space has been remarkable. From January 30th, the day the news broke, to today the sector is down 8.5%. Technology, which has seen much more negative news flow, is only 3.7% lower over the same period.

Our take: if sentiment on the group can be so roughed up by this news, what will happen when AMZN/BRKA/JPM name a CEO? Apparently that’s in the works with some very senior attention from Berkshire and veteran VC investor John Doerr. This is some strong poison indeed…

Rate Sensitive Groups (Utilities, REITs, Consumer Staples, Telecomm) Poisons

  • Higher Interest Rates. Pretty obvious, but for the sake of completeness we will cover it. All these groups have underperformed this year as long-term interest rates have risen.

Our take: our recent DataTrek investor survey showed remarkable conviction that the US 10 Year Treasury would end the year with a yield of between 3.0% and 3.25%. We agree with that assessment. And against that backdrop, it is hard to like any of these groups. Prudence says an “even weight” position in large sectors like Staples and  Utilities is the wise approach, just in case the crowd is very, very wrong.

Consumer Discretionary Poisons

  • Amazon and Netflix. Consumer Discretionary stocks have posted a solid 2018 thus far (up 2.9%), but only because Amazon is +21% on the year and Netflix is 51% higher YTD. Amazon (a 20% weighting) has added 420 basis points of performance, and Netflix (4.4% weighting) has been good for 150 bp more. In aggregate, everything else in this group is down 2.8% on the year and underperforming the S&P 500.

Our take: if you want to own Amazon, just own Amazon; the same goes for Netflix. If your investment approach is to just pick sectors, then you still need to own this group. This is one of those cases where the antidote – underweighting a group with important leadership names – may be worse than the poison (a very chunky sector in terms of single name risk).

Financials Poison

  • US Treasury Yield Curve. Financials have held their own this year, down 1.0% versus the S&P 500’s -1.2% price return. Holding them back: a narrowing spread between short and long term rates.

Our take: even in the last few days of market turmoil, long term Treasury rates held in at 2.72%. That is well above where they started the year (2.45%) and shows that even in a “Flight to quality” selloff there still isn’t much appetite to own long dated government paper. This gives us some confidence that long-term interest rates will continue their generally upward trajectory in 2018. Financials should be pulled higher in their wake.


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