Tech Hardware, Storage & Peripherals

Overweight The S&P tech hardware, storage & peripherals (THSP) index bounced yesterday on the back of index heavyweight Apple’s results. While the relatively weak results had long been telegraphed to the market and the upcoming quarter’s guidance was underwhelming, the company’s stock saw a relief rally based on the absence of a further deterioration in results. Importantly, the index’s valuation continues to trail the broad market by more than 20% (second panel), though dissecting this is significant. Apple’s net cash position is well known by the market which, as of the most recent quarter, stood at more than $27/share. While the overall S&P THSP index has moved to a net debt positive position, the spread versus the broad market ex-financials remains close to 1.5 turns of EBITDA (bottom panel). Adjusting for this would bias the P/E ratio even lower, creating in our view an unreasonable discount. Bottom Line: With the slowdown in China being a known known and resolution of the trade dispute a potential positive catalyst,1 the worst case appears to be priced in to Apple. We reiterate our overweight recommendation for the S&P THSP index and are removing our downgrade alert. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP.   1      Please see BCA U.S. Equity Strategy Weekly Report, “Trader’s Paradise” dated January 28, 2019, available at uses.bcaresearch.com.  

  Overweight (downgrade alert) The S&P tech hardware, storage & peripherals (THSP) index has been falling from its late-summer peak, caused first by weak quarterly guidance from Apple (which comprises close to 90% of the index) and since worsened by last week’s announcement that softness from the key China market would see revenues miss even that lowered bar. This hardly seems surprising in the context of currencies that have not performed to Apple’s benefit as the decline in the RMB (shown inverted in the bottom panel) would mean that even if unit sales held flat, translation would see a fall in Chinese sales. Further, growth in Asian exports and sentiment on Apple’s earnings are tied at the hip (second panel); with a trade war compounding a clearly softer Chinese consumer, a step down in earnings estimates seems logical. Still, the news is not all bad as the core domestic market remains resilient. U.S. consumer spending on electronics is at a multi-year high (third panel) and the currency headwinds to top line growth should prove to be tailwinds to margins, considering the imported content of Apple’s products. Bottom Line: We view the recent pullback in the S&P THSP index as the reset button being pressed and accordingly we reiterate our overweight recommendation. However, we note our existing downgrade alert on the index;1 further deterioration in China would be a likely catalyst to trigger such a move. The ticker symbols for the stocks in this index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP.   1 Please see BCA U.S. Equity Strategy Insight Report, “The Falling Apple And The Law Of Gravity,” dated November 13, 2018, available at uses.bcaresearch.com.  

Overweight (downgrade alert) In an August Insight Report, we noted the stratospheric rise of Apple was the key driver of the S&P 500's exceptional run and the S&P tech hardware, storage & peripherals (THSP) index's stellar outperformance.1 In that report, we suggested that clients institute a stop in this high-conviction call at the 10% relative return mark; Apple's fall since the weak outlook provided in their recent earnings report triggered that stop on Friday. Accordingly, we have booked the 10% gain since the April 9, 2018 addition of the S&P THSP index to our high-conviction list. The core rationale for our initial high-conviction overweight recommendation was our capex upcycle theme. However, capex intentions have rolled over, albeit from extended levels, and that should reveal itself in lower real capital deployment growth in general (second panel). More specific to the S&P THSP index, the decelerating investment growth has been pronounced in computers and peripheral equipment (bottom panel), which is corroborated by Apple's slowing sales expansion. Our thesis is thus somewhat dented and we are also compelled to add it to our downgrade watch list. Bottom Line: The recent pullback in the S&P THSP index triggered our stop last Friday and we locked in gains of 10% since inception. The S&P THSP index is now off our high conviction overweight list and we also put it on downgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP. 1 Please see BCA U.S. Equity Strategy Insight Report, "Tech Hardware Is On Fire," dated August 31, 2018, available at uses.bcaresearch.com.

  Overweight (High-Conviction) The S&P tech hardware, storage & peripherals (THSP) index has been an outstanding performer on our high-conviction list, returning more than 15% relative to the S&P 500 in the less than five months since it was added. Importantly, none of the key themes that drove our addition have finished playing out; the U.S. capex indicator remains persistently elevated, S&P THSP profit margins and the resulting cash flow remain robust and leverage ratios continue to lead the market (second & third panels). However, the breadth of the advance has narrowed as much of the outperformance has been due to Apple and the last two quarters of spectacular earnings beats. This adds a degree of specific risk to the exceptional S&P THSP outperformance. On top of this, risk of an escalating trade war with China continues to climb, to which the S&P THSP index is highly exposed. Accordingly, this morning we suggest that clients institute a stop in this high-conviction call at the 10% relative return mark, in line with our late-January introduced risk management policy. Bottom Line: We reiterate our high-conviction overweight status in the S&P THSP index, but recommend a 10% stop. The ticker symbols for the stocks in this index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP.    

As the SPX and a slew of other indices have vaulted to fresh all-time highs, a deeper dive into profit margins is in order. While the S&P 500's profit margins are benefiting from the one-time fillip of lower corporate taxes in calendar 2018, it is important to remember that this is not affected by any massaging from CEOs/CFOs of the share count. In other words, given that "per share" cancel out of EPS/SPS, this margin number represents organic profit and revenue growth. The chart shows that SPX margins have recently slingshot to all-time highs. However, excluding tech they remain below the previous cycle's peak hit in mid-2007. While we are not fans of excluding sectors from our analysis, the magnitude and persistence of the tech sector's profit margin expansion is surprising. Tech sector profit margins are twice the SPX's margins, and tech stocks have been pulling SPX margins higher consistently for the past 8 years. The implication is that SPX EPS growth of 10% is likely in 2019, but the tech sector has to continue doing all the heavy lifting given the high profit and market cap weight in the SPX. Bottom Line: We remain neutral the broad tech sector and prefer the S&P software and S&P tech hardware, storage & peripherals indexes (both are high-conviction overweights) to the early cyclical tech indexes, S&P semis and S&P semi equipment subgroups (both are underweight). For additional details, please look forward to reading in this coming Tuesday's Weekly Report.

Overweight (High-Conviction) The S&P tech hardware, storage & peripherals (THSP) index touched a new all-time relative high this week on the back of another stunning earnings outperformance by Apple. In our opinion, there are three numbers worth highlighting. First, iPhone pricing is surprisingly resilient, despite seasonality and what was supposed to be a weakening smart phone market. Second, high-margin services are growing at a rate above 30%, a significant step in transitioning the company from its hardware focus. Lastly, we estimate revenues from the key Chinese market grew by 25%, excluding currency, even though a trade war is heating up. Overall, it's hard to see what stands in Apple's way. From a higher level, we continue to point to the index's pristine balance sheets, which should support ongoing share repurchases (recall Apple has $140 billion of net debt with a commitment to bring it to zero and a $100 billion share repurchase program this year). Further, with valuations that trail the overall market, we think all the good news has yet to be priced in. We reiterate our high-conviction overweight recommendation on the S&P THSP index. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP.

Special Report

Highlights The regulatory or "stroke of pen" risk is rising on FAANG stocks - Facebook, Apple, Amazon, Netflix, and Google; The U.S. anti-trust regulatory framework was designed to curb anti-competitive actions but has evolved to focus mostly on consumer welfare and prices; A shift toward the original regulatory regime would threaten the FAANGs, particularly Google and Amazon; A trade war hit to tech earnings could be the catalyst for a more general selloff today - but this is not our base case; For now, the market will view regulatory risk as noise and tech stocks will likely enter a blow-off phase; We remain neutral, preferring S&P software and hardware while underweighting semiconductors. Feature "I don't know what Twitter is up to." Rep. Devin Nunes (R-California), Chairman of the House Intelligence Committee, July 29, 2018 "I have stated my concerns with Amazon long before the Election. Unlike others, they pay little or no taxes to state & local governments, use our Postal System as their Delivery Boy (causing tremendous loss to the U.S.), and are putting many thousands of retailers out of business." President Donald J. Trump, March 29, 2018 "If we will not endure a king as a political power, we should not endure a king over the production, transportation, and sale of any of the necessities of life. If we would not submit to an emperor, we should not submit to an autocrat of trade, with power to prevent competition and to fix the price of any commodity." Senator John Sherman, 1890 Social media companies have had a terrible week, with Twitter falling 21% on July 27th and Facebook 19% on July 26th. Facebook posted weaker than expected earnings, but investors appeared to be particularly concerned with a miss in monthly active users. The shortfall in active users may have been affected by the new EU privacy rules, which came into force in May. Twitter's fall from grace came even though its revenues were up 24% on the year, with a record profit of $100 million. However, its effort to delete "bots" and suspicious user accounts brought its user total down to 335 million, from 336 million, prompting fears that the platform was slowing down. Twitter's and Facebook's enormous price volatility, despite decent earnings figures, reveals that investors are jittery about the performance of technology stocks, epitomized by the so-called FAANGs - Facebook, Apple, Amazon, Netflix, and Google. They are right to be, given that there are three broad risks to these companies: The next big thing: Before Facebook, there was MySpace. It is not inconceivable that new platforms - for instance, ones that emphasize privacy or that redistribute a portion of advertising revenue with users - could replace current market leaders. Revenue model: Although they are perceived to be cutting-edge technology companies, social media firms generate vast amount of their revenue through advertising. Facebook and Google have captured 25% of global media advertising revenues.1 At some point, Internet companies will reach a ceiling on this revenue as the attrition rate of local newspapers slows, as foreign markets introduce local alternatives (RenRen or Weibo in China, VKontakte in Russia), and as non-tariff barriers to trade begin impacting their international expansion (China's Internet Security Law). Regulation: Finally, regulatory pressure could grow for a number of reasons. First, European concerns regarding user privacy could migrate to the U.S. where a majority of voters already believe that tech companies need greater oversight (Chart 1). In fact, Americans now see tech companies as having as pernicious an influence as energy companies (Chart 2). Second, the U.S. approach to anti-trust problems could evolve away from the current paradigm that focuses on delivering lower prices to consumers. Third, President Trump and his conservative allies could target social media companies with perceived liberal bias for purely political reasons. Chart 1Majority Of Americans Want Tech Regulated Chart 2Tech And Energy Companies Now In Same Boat We have no particular insight into the competitive landscape of social media, web browsing, and Internet retail industries, so we will leave the first two threats to the experts in the field. Instead, we will focus in this report on the third threat, the "stroke of pen" regulatory risk. From Standard Oil To The Chicago School - America's Anti-Trust Framework Today's anti-trust regulatory framework has significantly deviated from the original intent behind the 1890 Sherman Act. As Lina M. Khan argues in "Amazon's Antitrust Paradox," "Congress enacted antitrust laws to rein in the power of industrial trusts, the large business organizations that had emerged in the late nineteenth century. Responding to a fear of concentrated power, antitrust sought to distribute it."2 Railroad construction in the late nineteenth century, largely financed by the municipal debt of farm-belt states, evolved from a shrewd capex investment in a new technology to a mania. To boost sagging profits, railroad barons fixed their prices to reduce competition. State anti-trust laws that emerged out of this era, the so-called "Granger laws," sought to curb monopolistic behavior by giving states control over railroad operations. These state laws ultimately coalesced into federal legislation, the 1890 Sherman Act. No trust had a larger impact on the U.S. legal and regulatory infrastructure than the case of Standard Oil in the early twentieth century.3 Although the company faced criticism in the immediate aftermath of the 1880s recession - particularly from the famous muckraking journalist Henry Demarest Lloyd - the dam broke for Standard Oil when the oil-price bubble popped in Kansas in 1904. A Standard Oil subsidiary - the Prairie Oil and Gas Company - decided to purchase oil by a specific gravity test, forcing some of the Kansas oil from the market. At the time, the oil boom in Kansas had turned many into stockholders in some prospecting company. When oil prices fell, so did the fortunes of these locals. The shock of the price collapse radicalized Kansas politics at the turn of the twentieth century. An idea for a state-owned oil refinery picked up steam in the state despite being labeled socialist. Ultimately, Kansas' delegation in the U.S. House of Representatives requested that the Secretary of Commerce investigate the causes of the low price of crude oil in the state. After several disastrous performances of Standard Oil executives on witness stands and in testimony, the federal government filed a petition against the company in November 1906. A large fine followed in August 1907. The 1890 Sherman Act and subsequent anti-trust policies were grounded in the theory of economic structuralism. "This view holds that a market dominated by a very small number of large companies is likely to be less competitive than a market populated with many small- and medium-sized companies." Through the 1960s, courts blocked mergers - both horizontal and vertical - and policed markets not only for size, or effect on consumer welfare, but also for conflicts of interest.4 In the 1970s and 1980s, however, the Chicago School approach gained prominence. The Chicago School rested on "faith in the efficiency of markets, propelled by profit-maximizing actors."5 While economic structuralists believed that the structure of an industry leads to market outcomes, Chicago School saw structure as the outcome of market dynamics, which themselves are sacrosanct. Chicago School adherents focused primarily on price dynamics and consumer welfare, ignoring how economic structures could create barriers to entry and thus uncompetitive markets. The most influential economist behind the Chicago School was Robert Bork, who asserted in his highly influential The Antitrust Paradox that the "only legitimate goal of antitrust is the maximization of consumer welfare."6 That said, his definition of consumer welfare was incredibly broad and revealed a clear corporate, if not a pro-monopoly, bias.7 The influential Chicago School ultimately impacted the Supreme Court, which declared in 1979 that "Congress designed the Sherman Act as a 'consumer welfare prescription.'"8 The Reagan Administration subsequently rewrote the 1968 merger guidelines to shift the focus purely to consumer welfare in the form of preventing monopolistic price increases and output restrictions. The government also stopped bringing anti-trust cases under the 1936 Robinson-Patman Act, which prohibits price discrimination by retailers among producers and vice versa. Bottom Line: The U.S. anti-trust regulatory framework was designed to curb broad anti-competitive actions of trusts. As Lina Khan discusses in her seminal article, these actions "include not only cost but also product quality, variety, and innovation."9 However, through subsequent regulatory evolution, the Chicago School has taken hold of the U.S. anti-trust process, solely focusing on consumer welfare and prices. We can draw two immediate conclusions from this historical overview of U.S. anti-trust policy. First, the laws on the books have not changed since World War Two. Despite the laws remaining the same, the theory of how to apply them in courts of law has dramatically changed, as economic structuralism gave way to the Chicago School's focus on prices and consumer welfare. If President Reagan and the courts could change how these laws are administered in the 1980s, then so can subsequent administrations and courts in the future. Second, a long period of slow growth, income inequality, and economic volatility - such as the 1870s-80s - can produce a political impetus for anti-trust policy. This was certainly the case for Standard Oil in 1911, which became a nation-wide boogeyman despite most of its transgressions occurring in the farm belt states. While the U.S. has not experienced a recession in almost a decade, it will eventually - and besides, income inequality is a prominent theme once again and a potential source of consumer discontent.10 A narrative could emerge - particularly if politically expedient - that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. Will FAANGs Be De-FAANGed? At BCA Research, we are neither regulatory nor policy experts. As such, we do not have insight into current regulatory activity involving social media companies, Google, or Amazon. The preceding section merely illustrates that the federal government's approach to the anti-trust process could change. Indeed, the Obama administration signaled that its approach could become more active. One quantitative approach that investors can use to assess the risk of anti-trust legislation is the Herfindahl-Hirschman Index (HHI). It is the most commonly accepted measure of market concentration, used by the Department of Justice in assessing whether a particular market is controlled by a single firm.11 Chart 3 shows our reconstruction of the HHI for the present-day era, with three examples from the past. Chart 3Market Concentration By Industry And Eras The 1911 refined petroleum sector harkens back to the aforementioned Standard Oil case; The 2001 Internet browser market refers to the United States v. Microsoft Corp that led to the June 2000 decision (later reversed on appeal) to break-up the software giant; The 1983 telecommunication sector illustrates the HHI for the telecom market at the time of the AT&T divestiture. The data is clear: of the five FAANG companies, only Google reaches a concerning level on the HHI measure. This has already made it a target of European authorities. On the other hand, competition within both streaming (Netflix, Amazon) and social networks (Facebook) appears relatively healthy. However, social networks could be at risk of European-style privacy protections. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes considerable compliance burdens on any company handling user data. California has already signed its own version of the law - the Consumer Privacy Act - which will go into effect in January 2020. These laws give consumers the right to know what information companies are collecting about them and what companies that data is being shared with. They also allow consumers to ask technology companies to delete their data or not to sell it. While tech companies are likely to fight the new California law, we believe the writing is on the wall. The EU is by some measures the largest consumer market on the planet. California is certainly the largest U.S. market. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. Given that advertising revenue is crucial to the business model of social media companies and Google, a significant uptick in privacy regulation could hurt their bottom line. On the other hand, as we discuss below, the new regulatory rules create massive barriers to entry for small firms looking to replace the tech giants. Furthermore, many of the targeted social media companies have run afoul of President Trump in particular and the broader conservative movement in general. As such, privacy advocates - who tend to lean left - and conservatives, who feel that their commentators are being silenced by Silicon Valley, could form a classic "bootleggers and abolitionists" coalition against the FAANGs (Chart 4). Finally, there is the question of Amazon. We do not construct an HHI for Amazon's place in the retail market because E-commerce only accounts for about 9.5% of total U.S. retail sales (Chart 5). Amazon has been leading the charge, but it still accounts for just under half of that 9.5% total figure (Chart 6). Chart 4Conservatives Distrust Tech Companies Chart 5E-Commerce: Steady Increase In Market Share Chart 6Amazon Dominates Amazon's strength is that, in the current anti-trust framework, it conforms fully to the "consumer welfare" priorities elucidated by the Chicago School. Amazon, by and large, lowers prices for consumers. However, several of its practices could be seen as predatory in the more expansive, economic structuralist, approach.12 In addition, President Trump has reserved most of his Twitter scorn on the firm, particularly because CEO Jeff Bezos owns the liberal-leaning Washington Post. Bottom Line: Investors are correct to fret that the "stroke of pen" risk is rising when it comes to FAANG companies. Google scores considerably higher than either Standard Oil or Microsoft on the Department of Justice HHI. Social media companies are already under the microscope by conservative legislators and voters, who perceive them to be biased. Liberals, on the other hand, support toughened-up privacy rules that could undermine the business model of social media companies. Amazon's market dominance is overstated. However, several of its business practices could come under greater scrutiny if any administration should revert back to the original reading of the 1890 Sherman Law. Technology Stocks Have Brought The S&P 500 Up; Could They Bring It Down? It is now a well-worn understanding that the reason why the S&P 500 has performed well is largely due to the performance of a few (enormous) technology stocks (see Chart 7 and Table 1) who have seen both earnings and valuation multiples expand amid one of the longest economic growth phases in history. The preceding section certainly suggests that frothy valuations and the rising regulatory impetus imply that future upside potential is swamped by downside risk. Chart 7FAANG Stocks + Microsoft Have##br## Dramatically Outperformed... Table 1...Generating 50% Of The##br## 2018 S&P 500 Return! If this negative scenario is what actually plays out in the market, the implications could be more severe than in the past. Indexed fund inflows have replaced actively managed fund outflows, as our colleagues in BCA's Global ETF Strategy recently pointed out (Chart 8).13 Considering the rise of these few technology stocks and their increasing weight in the S&P 500 and, necessarily, in the majority of ETFs, more people than ever before are invested in technology stocks, whether they know it or not. Accordingly, the performance of these stocks has become material to the household balance sheet, which is a driver of consumption and, hence, the economy. Thus, it may not be hyperbole to say the economy depends to some extent on Amazon maintaining a high valuation multiple. Chart 8ETF Inflows Offset Actively Managed Outflows Adding some weight to this thesis is the mounting concern over a global trade war. The technology sector in general is by far the most international (as defined by foreign-sourced revenues) of GICS 1 sectors. More specifically, the top three semiconductor & semiconductor equipment companies (INTC, NVDA & TXN), which collectively represent more than 50% of the weight of that index, generate on average only 17% of their revenues in the U.S. Moreover, the more dangerous and lasting trade risk emanates from the U.S.-China showdown, which centers on the technology sector. Should the worst trade outcomes occur, it is not unreasonable to see impaired technology earnings being the catalyst for a more general sell-off. We recommend underweight positions in both the S&P semiconductors and S&P semiconductor equipment indexes. We Think Not Despite the foregoing, we think a more likely scenario is actually a blow-off phase where technology stocks accelerate rather than decline in an increasingly restrictive regulatory environment. In a recent report analyzing sector performance in the last stages of the bull market, we noted that across seven iterations dating back to the 1960's, the information technology sector delivered a median 14% outperformance relative to the S&P 500 (Table 2).14 And, while returns in these stocks have been excellent this year, their gains seem modest compared to the performance in the 1999-2000 iteration. Table 2Tech Stocks Are Strong Late Cycle Performers Underpinning our expectations is the recent stock reactions to regulatory actions. Beginning with Facebook, in the week of March 26, 2018, the firm was hit with severely negative headlines. First, the Cambridge Analytica scandal pointed out that the firm may be caught on the wrong side of EU GDPR rules, followed by the firm being investigated for an EU antitrust suit for the online ad market; the stock fell 15% from the week prior. However, within two months, the stock had fully recovered and a further two months later the stock was up 18% from its starting point. Recently the stock has fallen significantly on the back of very weak guidance; the company noted that revenue growth would decelerate and operating margins would fall to the mid-30% range from the current mid-40% range. It is not unreasonable to think management may be sandbagging earnings growth to defray some of the elevated regulatory scrutiny into its outrageous profitability. Google too has seen negative regulatory headlines, having been hit with a $5 billion fine in the EU for abusing the dominance of the Android mobile operating system in July this year. The stock responded by closing higher and then rose a further 10% in the following two weeks. Overall, we think the market views regulatory risk as noise. For now. But What About The Earnings? Do They Matter? While the earnings implications of yet-to-be-proposed regulatory changes are unknowable, we believe even the pursuit of an answer is a red herring. As shown by Chart 9, the market does not appear to care about next year's earnings as valuation multiples have little consistency with either themselves or the broad market. The implication is that near-term earnings are of relatively little importance, at least compared to the long-term growth outlook. Chart 9Tech Valuations Are Meaningless Further, these companies are a collection of businesses that are not necessarily cohesive. For example, Facebook includes Instagram, WhatsApp and Oculus while Amazon Web Service is a non-retail business that delivers half of Amazon's profit. A reasonable case could be made that breaking up these companies into their components could actually unlock considerable value. Lastly, new regulation, particularly with respect to privacy and data protection, is likely to create significant barriers for new entrants as compliance costs will be relatively more onerous for those companies with fewer resources. Thus, incoming privacy legislation may neuter the impact of any anti-trust legislation. Be Wary With Technology But For The Right Reasons We fully expect more regulation to remain a significant part of the conversation with respect to FAANG stocks and further expect that conversation to promote higher than normal volatility in the sector. However, we also expect the market to mostly look through this risk; buying the dip has thus far been the right approach to headline risk in technology. We think there are better reasons to remain cautious with technology. As noted above, they are heavily international and a strengthening U.S. dollar will be a headwind to 2019 earnings to a greater extent than to the broad market (please see our June 4th Weekly Report for more details). Supporting the dollar, BCA expects higher interest rates in 2018 on the back of rising inflation. Overall, we prefer old tech (S&P software and S&P technology hardware, storage & peripherals, both which are high-conviction overweights) that is levered to our synchronized global capex upcycle theme. It also boasts high cash flow and low valuations. We are less sanguine about technology early cyclicals (S&P semiconductors and S&P semiconductor equipment) which we rate as underweight. Net, we think risks are balanced in the tech sector and maintain a neutral recommendation for the S&P information technology sector. BCA Geopolitical Strategy Housekeeping In light of several announcements regarding China's efforts to ease up on economic policy, we are closing several of our trades: Short China-exposed S&P 500 Companies versus U.S. financials and telecoms - opened on May 30 for a 7.13% gain; Long DXY - opened on January 31 for a 5.85% gain; Short GBP/USD - opened on February 14 for a 6.21% gain; Long Indian equities / short Brazilian equities - opened on March 6 for a 27.54% gain. Long French industrial equities / short German industrial equities - opened on May 16 for a 2.21% gain. We still believe that Chinese structural reforms will continue, weighing on domestic and global growth. In the face of ongoing U.S. fiscal stimulus, the interplay between the two major economies will therefore continue to produce a dollar-bullish environment. However, the dollar's stretched positioning and the Chinese reflation narrative could hurt the greenback while reflating global risk assets in the near term. We will therefore look for an opportunity to reassert our negative EM view. Over the next two weeks, our reports will focus on Chinese stimulus and ongoing structural reforms. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see WARC, "Mobile is the world's second-largest ad medium," dated November 30, 2017, available at warc.com. 2 Please see Lina M. Khan, "Amazon's Antitrust Paradox," The Yale Law Journal 126:710 (2017). 3 Please see Steven L. Piott, The Anti-Monopoly Persuasion (Westport, Connecticut: Greenwood Press, 1985). 4 Khan 718. 5 Khan 719. 6 Please see Robert H. Bork, The Antitrust Paradox: A Policy at War with Itself (New York: Free Press, 1978). 7 By Bork's broad definition of "consumer welfare," even Jeff Bezos is a consumer whose rights have to be protected by anti-trust policy. "Those who continue to buy after a monopoly is formed pay more for the same output, and that shifts income from them to the monopoly and its owners, who are also consumers. This is not dead-weight loss due to restriction of output but merely a shift in income between two classes of consumers. The consumer welfare model, which views consumers as a collectivity, does not take this income effect into account," Bork, 32, our emphasis. 8 Please see Reiter v. Sonotone Corp., 442 U.S. 330, 342 (1979). 9 Khan 737. 10 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 11 Please see The U.S. Department of Justice, "Herfindahl-Hirschman Index," available at justice.gov. 12 Please see Olivia LaVecchia and Stacy Mitchell, "Amazon's Stranglehold: How the Company's Tightening Grip Is Stifling Competition, Eroding Jobs, and Threatening Communities," Institute for Local Self-Reliance, dated November 2016, available at ilsr.org. 13 Please see BCA Global ETF Strategy Special Report, "Do ETF Flows Lead Currencies?" dated April 18, 2018, available at etf.bcaresearch.com. 14 Please see BCA U.S. Equity Strategy Special Report, "Portfolio Positioning For A Late Cycle Surge," dated May 22, 2018, available at uses.bcaresearch.com.

Overweight (High-Conviction) We lifted the S&P tech hardware, storage & peripherals (THSP) index to a high conviction overweight last month on the back of our expectation of ongoing rising global capex, a key BCA investment theme for 2018, boosted by exceptionally cash-laden balance sheets (second panel) that we thought would drive shareholder-friendly activities that had not already been priced in to the market (third panel). Apple (by far the largest constituent company) did not disappoint with their results after the close on Tuesday. For much of April, the S&P THSP index had been trading down after anecdotal evidence pointed to sliding demand for smartphones in general and the flagship Apple iPhone X in particular. Apple CEO Tim Cook rebuffed such claims, stating that the iPhone X was the most popular iPhone in every week of the quarter and grew in every geography globally; the company took the opportunity to lift the next quarter's revenue guidance above analyst estimates. Perhaps more importantly, Apple announced a new $100 billion share repurchase program, on top of the previous $210 billion share repurchase program scheduled to be completed next quarter, and a 16% increase in the dividend. Even these actions, however, will not be enough to meet the company's goal of eliminating their $145 billion net cash pile; stay tuned for more and stay overweight the S&P THSP index. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP.

Overweight (High Conviction) As highlighted in this week's Weekly Report, we are moving to a benchmark allocation in the S&P information technology sector. The way we are executing the upgrade is by lifting the S&P tech hardware, storage & peripherals (THSP) index to an overweight stance. We are also adding this index to our high conviction overweight list. Building on the capex upcycle theme, U.S. tech hardware manufacturers also benefit from improving animal spirits and rising capital expenditures. U.S. capex intentions are as good as they can get, hanging near multi-decade highs (second panel). Importantly, global trade remains buoyant and signals that the global export pie is increasing in size. The tech-laden Korean and Taiwanese stock markets have positive momentum and are an excellent leading indicator of tech-heavy EM Asian exports. The current message is to expect a durable export growth phase in the coming months (third panel). Meanwhile, this industry that generates excessive amounts of free cash flow and sports a net debt/EBITDA ratio below par (bottom panel) will continue to be extremely generous to shareholders by continuing to aggressively retire equity and boost dividend payouts. Bottom Line: Boost the S&P THSP index to an overweight stance and add it to the high-conviction overweight list. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP.

Highlights Portfolio Strategy The capex upcycle, a soft U.S. dollar and improving end demand signal that it no longer pays to underweight the S&P tech sector. Lift exposure to neutral. Firming domestic and global final demand, the synchronized global capex upcycle, an overly pessimistic sell-side analyst community and cheap valuations compel us to upgrade the S&P tech hardware, storage & peripherals index to overweight. Recent Changes S&P Technology - Upgrade to neutral today. S&P Tech Hardware, Storage & Peripherals - Boost to overweight and add to the high-conviction overweight list today. Table 1 Feature The S&P 500 seesawed last week, and continues to absorb the early February drawdown. While global growth cannot continue its breakneck pace indefinitely and a soft patch is inevitable, global output growth remains significant and above trend. Our constructive cyclical equity market view remains intact, premised upon the longevity of the business cycle, at least for the next 9-12 months. In the U.S. specifically, the ISM manufacturing survey is perched closer to 60 than to 50, unemployment insurance claims hover near 50-year lows and the muted 10-year Treasury yield moves all signal that generalized fear has yet to grip markets (Chart 1). In fact, if one looks back at the 2015, 2011 and 2010 global growth scares, investors took shelter in U.S. Treasuries as the SPX sold off, sending the 10-year UST yield lower by 50, 70 and 70 bps respectively in a very short time span. The fact that the 10-year yield is only 15 bps below its peak should cause us to question whether the recent equity drawdown is really about slowing global growth. On the monetary policy front, while the Fed is increasing the fed funds rate and decreasing the size of its balance sheet and volatility is making a comeback (please see Chart 1 from the March 5th Special Report), the real fed funds rate remains below the zero line and the real 10-year UST yield is also close to nil (Chart 2). Economic slack measures confirm that the Fed remains behind the curve. The output and unemployment gaps have been closed for a while now, and BCA's unemployment diffusion index and the Taylor rule both signal that monetary policy is extremely accommodative (Chart 3). Chart 1Macro Conditions... Chart 2...Remain Conducive... Chart 3...To A Rising SPX The implication is that macro conditions remain conducive to a rising equity market from a cyclical time horizon perspective. Meanwhile, sifting through the noise reveals that the market is likely coming to grips with a calendar 2019 EPS growth of a more reasonable 10% annual rate compared with this year's near 20% peak growth rate. This transition, as we highlighted in recent research, will be turbulent,1 and likely an earnings validation phase will pave the way higher for the broad equity market. In fact, dissecting the tax relief impact on different sectors is in order. Charts 4 & 5 show the calendar 2018 forward estimates on December 31st, 2017 and what analysts pencil in today, respectively. Charts 6 & 7 highlight the delta in absolute terms and percentage change terms. Chart 42018 EPS Growth On March 30, 2018 Chart 52018 EPS Growth On December 31, 2017 Chart 6Delta Chart 7Delta % Change Telecom services will likely benefit tenfold from the lower corporate tax rate (shown truncated, Chart 7), and consumer discretionary stocks are also prime beneficiaries. But this also means that 2018 after-tax profit data are masking the negative underlying trend growth rate for both of these sectors which also sport grim operating metrics. The S&P telecom services sector is a high-conviction underweight,2 and we reiterate our recent downgrade to a below benchmark allocation in the S&P consumer discretionary sector.3 Industrials, energy and financials, also benefit greatly from tax relief (Chart 7), but higher commodity prices along with improving industry operating metrics contribute to the EPS euphoria for these sectors. Nevertheless, we have identified three key risks to our sanguine equity market view: Escalating geopolitical/regulatory uncertainty Severe global growth slowdown U.S. dollar surge All three risks are intertwined and could infiltrate profit growth in the coming months. As we have posited in recent research, U.S. dollar softness begets higher global growth and the two feed off of each other in a virtuous cycle. A depreciating currency is a profit fillip for SPX constituents with heavy export exposure, the opposite is also true (Chart 8). Chart 8S&P 500: Aggregate Sector International Revenue Exposure (%) If the Trump Administration continues to slap on tariffs with China retaliating, as we experienced last week, eventually triggering a global trade war, then all bets are off on the sustainability of global growth (Chart 9). Such an outcome would weigh heavily on both market sentiment and profits, as our Geopolitical Strategists argued last week.4 Chart 9Don't Throw In The Towel On Global Growth Yet Finally, regulatory clampdown on the tech sector specifically is also on our radar screen, especially given the monopolistic powers that a handful of U.S. tech titans command. This is not only a U.S. risk, but also a global one. However, the 2000s Microsoft and recent Google precedents suggest that a corporate breakup is a low probability event à la "Ma Bell" in 1983, and heavy fines are the most likely outcome (we will be covering this regulatory risk in an upcoming Special Report in conjunction with our sister Geopolitical Strategy publication, stay tuned). Adding it up, we assign low probabilities to all three risks. This week we are taking advantage of recent market weakness and adding some cyclical exposure to our portfolio. Lift Tech To Neutral... We have been offside on tech sector positioning, but are not dogmatic and given recent market action and positive changes in a number of key drivers, we recommend acting on our mid-January upgrade alert, booking losses and lifting exposure to neutral.5 Before exploring our thesis on why we are becoming more constructive on the largest S&P sector in terms of market capitalization weight, it is instructive to look back and identify what we missed. Two reasons for the tech sector's outperformance stand out. First, BCA's constructive view on the U.S. dollar has weighed heavily on our underweight positioning in the tech sector, especially since the greenback's peak in level terms in December 2016. U.S. tech firms garner 60% of their total revenues from abroad - the highest among the GICS1 sectors (Chart 8) - and the positive P&L translation gain effects have been a tonic to EPS. Irrespective of where the dollar will end 2018, due to lagged effects, the U.S. dollar's significant depreciation will continue to boost tech sector EPS. Second, the lack of inflation at this stage of the cycle has perplexed economists and presented a goldilocks macro backdrop for the tech sector that thrives in deflation/disinflation. This benign inflation backdrop has also coincided with the V-shaped global growth recovery following the late-2015/early-2016 global manufacturing recession and propelled technology stocks. Nevertheless, in mid-September we lifted the S&P software index to a benchmark allocation and subsequently to a high-conviction overweight in late-November in order to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle. Building on this thesis, the broad tech sector also benefits from rising capex (Chart 10). In fact, there is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. Not only is the tech sector gaining capex market share, largely at the expense of basic resources (Chart 11), but also in absolute terms tech spending is on fire and vaulting to fresh all-time highs (Chart 10). Chart 10Prime Capex Beneficiary Chart 11Sector Capex % Of Total National accounts confirm the stock market-reported capital outlays data and tech investment is firing on all cylinders (middle panel, Chart 12). In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end-demand is upbeat (fourth panel, Chart 12). The San Francisco Fed's Tech Pulse Index encapsulates all this tech optimism underpinning tech stocks (second panel Chart 12).6 On the global demand front, EM Asian exports are climbing at the fastest clip in ten years, despite the smart rebound in the ADXY. Historically, tech sales and EM Asian exports are joined at the hip and the current message is positive (bottom panel, Chart 12). Importantly, a rising revenue backdrop is necessary, especially in the context of rising capital outlays, as they sustain the virtuous upcycle. A simple final demand indicator combining tech exports and new orders is also flashing green (Chart 13). Tack on the sizable losses in the U.S. dollar over the past year and resurgent tech exports will be a boon to tech EPS (bottom panel, Chart 13). Chart 12Firm End-Demand Chart 13Soft U.S. Dollar Helps Our tech profit model does an excellent job capturing all of these positive forces and is pointing to healthy growth for the rest of 2018 (second panel, Chart 14). However, there are also a few headwinds that the tech sector has to contend with and that prevent us from lifting exposure all the way to overweight. First, any knee-jerk bounce in the U.S. dollar is a clear negative for technology stocks. Second, BCA's second key theme we are exploring calls for higher interest rates in 2018 on the back of rising inflation (Chart 15). Were the selloff in the bond market to gain steam in the coming months as inflation rears its ugly head, then tech stocks would come under intense pressure. Third, as we highlighted above, regulatory/political risks have been at the epicenter of the recent tech sector wobble, and heightened regulatory uncertainty will continue to muddy the tech waters. Finally, while tech stocks are nowhere near as overvalued as in late-1999/early 2000, they are more expensive than the broad market on a number of valuation measures (third panel, Chart 14). Chart 14Our Tech Profit Model Flashes Green... Chart 15...But Interest Rates Are A Big Headwind Netting it all out, we are compelled to lift exposure in the S&P information technology sector to neutral, by augmenting the S&P tech hardware, storage & peripherals (THSP) index to an overweight stance. ...Via Boosting Tech Hardware To Overweight The way we are executing the upgrade to neutral on the broad S&P tech sector is by lifting the S&P THSP index to an overweight stance. We are also adding this index to our high-conviction overweight list. Building on the capex upcycle theme, U.S. tech hardware manufacturers also benefit from improving animal spirits and rising capital expenditures. U.S. capex intentions are as good as they can get, hanging near multi-decade highs (second panel, Chart 16). Already, U.S. factories are humming trying to fulfill perky end-demand. Industry production is far outpacing capacity growth and this represents a boon to pricing power that has exited deflation for the first time ever (bottom panel, Chart 16). The implication is that S&P THSP profits will overwhelm. Beyond U.S. shores, global fixed capital formation is also climbing sharply. This synchronized global capex upcycle represents a tailwind for this industry and will continue to underpin U.S. computer exports (Chart 17). Add on the depreciating greenback and U.S. manufacturers are well positioned for export market share gains (third panel, Chart 17). Chart 16Capex To The Rescue Chart 17Enticing Global ... Importantly, global trade remains buoyant and signals that the global export pie is increasing in size. In particular, EM Asian exports are expanding at a healthy clip, in spite of rising EM currencies, underpinning S&P THSP net earnings revisions (middle panel, Chart 18). The tech-laden Korean and Taiwanese stock markets have positive momentum and are an excellent leading indicator of tech-heavy EM Asian exports. The current message is to expect a durable export growth phase in the coming months (Chart 18). All of this suggests that S&P THSP sales and profits will shine in 2018, easily surpassing the extremely low relative hurdles that sell-side analysts are penciling in for the coming 12 months (second & third panels, Chart 19). Meanwhile, this industry that generates excessive amounts of free cash flow and sports a net debt/EBITDA ratio below par (Chart 20) will continue to be extremely generous to shareholders by continuing to aggressively retire equity and boost dividend payouts. Return on equity is also probing all-time highs. Chart 18...Demand Backdrop Chart 19Unwarranted Pessimism... Chart 20...Given Pristine B/S And Sky-High ROE Finally on the relative valuation front, this tech sub-index trades at a 20% discount to the broad market (and below the S&P tech sector) both on a forward P/E and EV/EBITDA basis, offering an appealing entry point. Bottom Line: Boost the S&P THSP index to an overweight stance for a loss of 16% since inception, and add it to the high-conviction overweight list. This shift also lifts the overall S&P tech sector to a benchmark allocation for a loss of 18% since inception. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2018, available at uses.bcaresearch.com. 6 "The Tech Pulse Index is an index of coincident indicators of activity in the U.S. information technology sector. It can be interpreted as a summary statistic that tracks the health of the tech sector in a timely manner. The indicators used to compute the index are investment in IT goods, consumption of personal computers and software, employment in the IT sector, as well as industrial production of and shipments by the technology sector. The index extracts the common trend that drives these series." https://www.frbsf.org/economic-research/indicators-data/tech-pulse/ Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).