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Inside the Market Why technology stocks are at risk for an even bigger tumble

Like a lot of market volatility, the recent downdraft endured by large-cap technology stocks is entirely understandable in hindsight. Economically sensitive sectors such as technology had been outperforming to an extent not supported by global growth, and the resulting correction is helping narrow the divergence.

Technology companies have often seemed like an unstoppable force as global economies become digitized but Richard Bernstein, former chief quantitative strategist at Merrill Lynch and founder of New York-based RB Advisors, has frequently warned that the sector is cyclical, with revenues highly dependent on global economic growth.

As a result, the stocks with the largest weightings in the MSCI USA Cyclical Sectors Index – a benchmark consisting of U.S. stocks with profits most affected by broad economic growth – are a who’s who of dominant technology companies. Microsoft Corp. is the biggest position in the index, Apple Inc. and Amazon.com Inc. are next, while Alphabet Inc. and Facebook Inc. are in the Top 10. Since the recent S&P 500 peak on May 3, these stocks have fallen 3.8 per cent relative to benchmark’s 2.4-per-cent drop.

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The accompanying chart highlights the significant outperformance of cyclical stocks relative to defensive sectors ahead of the recent market correction. The blue line represents the year-over-year change in the MSCI Cyclical Sectors-Defensive Sectors Return Spread Index, which is calculated by the hypothetical returns generated by owning the MSCI USA Cyclical Sectors Index and shorting the MSCI USA Defensive Sectors Index. (The latter is composed of companies with profits least affected by economic growth such as pharmaceuticals, consumer staples and utilities.)

The purple line is the annual change in the JPMorgan Global Manufacturing PMI Index – a proxy for global economic growth.

Technology and cyclical stocks at

risk until economic data improve

MSCI Cyclical Sectors-Defensive Sectors

Return Spread Index (YoY) (Left scale)

JPM Global Manufacturing

PMI Index (YoY) (Right scale)

25%

8%

6

20

4

15

2

Current

reading

10

0

5

-2

0

-4

-5

-6

-10

-8

2016

2017

2018

2019

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: scott barlow; bloomberg

Technology and cyclical stocks at

risk until economic data improve

MSCI Cyclical Sectors-Defensive

Sectors Return Spread Index (YoY) (Left scale)

JPM Global Manufacturing

PMI Index (YoY) (Right scale)

25%

8%

6

20

4

15

2

Current

reading

10

0

5

-2

0

-4

-5

-6

-10

-8

2016

2017

2018

2019

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: scott barlow; bloomberg

Technology and cyclical stocks at risk

until economic data improve

MSCI Cyclical Sectors-Defensive

Sectors Return Spread Index (YoY)

JPM Global Manufacturing

PMI Index (YoY)

25%

8%

6

20

4

15

2

Current

reading

10

0

5

-2

0

-4

-5

-6

-10

-8

2016

2017

2018

2019

JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: scott barlow; bloomberg

Beginning in May, 2016, an extended acceleration in global economic growth was quickly followed by a period of cyclical stock outperformance (indicated by the rising blue line, the Return Spread Index). From July, 2017, to January, 2019, the trend reversed as the global economy slowed and defensive stocks began performing more strongly relative to cyclicals.

An important divergence occurred at the end of February, 2019. Led by the technology sector, cyclical stocks began ramping higher but global growth rolled over and headed south. Through March and April, the rally in cyclical stocks became increasingly unsupported by the global economy.

The divergence has closed a bit with recent equity market volatility, but still likely has a ways to go. The Cyclical Sectors-Defensive Sectors Return Spread Index is currently lower by 0.17 per cent relative to May 31, 2018 – this is shown by the dotted blue line on the chart.

Historical patterns suggest that the blue line on the chart will eventually reconnect with the year-over-year change in global economic growth. This can happen by technology and cyclical stocks continuing to underperform defensive sectors – dragging the MSCI index lower – or by global growth data improving, or by a combination of the two.

The chart has important implications for investor portfolios in that large-cap tech stocks and other economically sensitive sectors will be at risk of correction until the global economic backdrop improves.

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