Technology

Highlights Portfolio Strategy Chinese reflation, the ongoing global capex upcycle, and the Fed induced cap on the greenback with the knock-on effect of higher commodity prices, all signal that it still pays to overweight S&P cyclicals at the expense of S&P defensives.  Sustained EM stock outperformance, a soft U.S. dollar, improving semi equipment operating metrics, along with compelling relative valuations and technicals, all suggest that there are high odds that the recent semi equipment run up has more upside.   Recent Changes There are no changes in the portfolio this week. Feature The SPX consolidated the 350 point advance since the Christmas Eve trough last week, setting the stage for a durable advance in the coming months. The Fed stood pat last Wednesday, and signaled a much more dovish policy stance going forward. Chairman Powell was clearly humbled by last December’s convulsing equity market and abrupt tightening in financial conditions. On that front, in the latest FOMC statement the explicit mention of patience is significant: “the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate”. A definitively more dovish Fed, which will help restrain the greenback, remains one of the three key catalysts for a durable equity market advance as we have highlighted in recent research.1 Encouragingly, our proprietary Equity Capitulation Indicator (ECI) has bottomed at two standard deviations below the historical mean (Chart 1). Over the past two decades, such a depressed level in our ECI has marked previous equity market troughs including the early-2016, 2011, 2002 and 1998 iterations. Only the GFC episode was lower, falling to three standard deviations below the mean. Clearly the late-December selling frenzy registers as another investor capitulation point and, if history at least rhymes, more gains are in store for the broad equity market. Chart 1Capitulation Capitulation Capitulation Chart 2 shows some other measures of breadth that corroborate our ECI’s message: investors hit the panic button and exited equities in droves in Q4. The upshot is that with selling exhausted, stocks can now stage a durable recovery as long as profits continue to expand. As a reminder, the continuation of the earnings juggernaut is the second key catalyst we identified two weeks ago.2 Midway through earnings season, SPX EPS have held up well with growth approaching 16%. For calendar 2019 we expect mid-single digit EPS growth in line with the signal from our macro driven S&P 500 EPS growth model (please refer to Chart 4 from the mid-January Weekly Publication).3 Chart 2Selling Is Exhausted Selling Is Exhausted Selling Is Exhausted A positive resolution to the U.S./China trade spat is the third catalyst we highlighted recently in order for equities to break out to fresh all-time highs.4 Related to this, China’s reflation efforts are equally important. On that front, news of quasi QE from the PBOC suggests that the Chinese authorities remain committed to injecting liquidity into their economy.5 Already, the PBOC balance sheet, with over $5.5tn in assets, is expanding anew. Empirical evidence suggests that SPX momentum and the ebb and flow of the PBOC balance sheet are joined at the hip, and the current message is positive (second panel, Chart 3). Chart 3Heed The PBoC Message Heed The PBoC Message Heed The PBoC Message Beyond the PBOC balance sheet expansion, the Chinese six-month credit impulse is also in a sling shot recovery. This Chinese credit backdrop is enticing and moves more or less in tandem with the SPX six-month impulse (top panel, Chart 4). Chart 4Reflating Away Reflating Away Reflating Away Two forces explain these relationships. First, China’s rise to become the second largest economy in the world along with its insatiable appetite for commodities and durable goods. Second, 40% of S&P 500 sales are international and an increasing share now originates in emerging markets in general and in China in particular. Keep in mind that the S&P cyclicals/defensives ratio is not only a high beta play on the SPX itself (top panel, Chart 3), but also an S&P global versus domestic gauge. Thus, both of these Chinese indicators also enjoy a positive correlation with the cyclicals vs. defensives tilt (bottom panels, Charts 3 & 4). With that in mind, this week we are drilling deeper into why we continue to prefer S&P cyclicals over S&P defensives and also highlight a highly cyclical index we went overweight in mid-December that has gone parabolic. Double Down On Cyclicals Vs. Defensives Early-October 2017 marks the initiation of our cyclical vs. defensive preference. Initially, this tilt jumped and peaked in mid-2018 returning 18% since inception. Since then, it has given up all of those gains and then some before troughing with the market on Christmas Eve, suffering a 6% drop since inception. Currently, the ratio has moved full circle and is back to where it was when we first recommended this portfolio bent (Chart 5). Chart 5Full Circle Full Circle Full Circle Should investors commit capital to this tilt at this stage of the cycle and given the current global macro backdrop? The short answer is yes. Charts 3 & 4 show that China’s reflation efforts and the fate of the S&P cyclicals/defensives ratio are closely correlated. In addition to the PBOC’s expanding balance sheet and rising Chinese credit impulse, Chinese monetary easing also benefits S&P cyclicals at the expense of S&P defensives. The Chinese reserve requirement ratio (RRR) has plummeted to the lowest point since the GFC and Chinese interest rates are also plumbing multi-year lows (RRR shown inverted, top panel, Chart 6). Chart 6China Flashing Green China Flashing Green China Flashing Green Tack on a resurgent currency with the CNY briefly breaking 6.70 with the U.S. dollar, and factors are falling into place for a playable rally in the cyclicals/defensive ratio. Likely, the Chinese are trying to appease President Trump by underpinning the yuan, but the Fed’s recent more dovish stance on interest rate hikes is also pushing the greenback lower. Taken together, this is a boon for the commodity exposed U.S. cyclicals that also garner a significant share of their sales from abroad (bottom panel, Chart 6). Commodity prices troughed last September, staying true to their leading properties and have been in recovery mode ever since (top panel, Chart 7). Now that the Fed has capped the U.S. dollar, more gains are in store for commodities and that is a boon for commodity producers’ top line growth prospects. Chart 7Capex Remains Healthy Capex Remains Healthy Capex Remains Healthy The demand backdrop is also enticing at the current stage of the business cycle, not only domestically, but also in China. Capital outlays remain upbeat and despite some recent turbulence, U.S. capex intentions are near multi-year highs (third panel, Chart 7). In China, recent piece meal fiscal easing announcements are far from negligible; already infrastructure spending has jumped after contracting late last year (second panel, Chart 7). Were these announcements to get supplemented by a bigger and more comprehensive package, then commodity-levered equities will excel further. A look at the relative balance sheet health of cyclicals versus defensives is revealing. Cyclicals are paying down debt and their cash flow continues to improve, still recovering from the late-2015/early 2016 global manufacturing recession. On the flipside, defensives are piling on debt. All four safe haven sectors have been degrading their balance sheets (relative net debt-to-EBITDA shown inverted, middle panel, Chart 8). Interest coverage sends a similar message: cyclicals are in excellent health both in absolute terms and compared with defensives (top panel, Chart 8). Chart 8B/S Improvement Continues B/S Improvement Continues B/S Improvement Continues Sell-side analysts have not yet taken notice of the macro tide that is turning in favor of cyclicals over defensives. Relative forward profit growth has collapsed to nil and net EPS revisions are at previous nadirs (fourth & fifth panels, Chart 9). Chart 9Oversold And Unloved Oversold And Unloved Oversold And Unloved In sum, if our thesis pans out that China will continue to reflate, global capex will remain vibrant, the greenback will drift lower (U.S. dollar shown inverted, top panel, Chart 9) courtesy of a dovish Fed that will push the broad commodity complex higher, then a significant valuation rerating looms for the cyclicals/defensives tilt (second panel, Chart 9). Bottom Line: Continue to the prefer S&P cyclicals to S&P defensives. We also reiterate our recent long S&P materials/short S&P utilities pair trade.6 Semi Equipment: Buy Into Strength In mid-December we boosted the S&P semi equipment index to overweight from underweight and since then this niche chip subindex has outperformed the broad market by 17%.7 Semi equipment stocks are high beta (bottom panel, Chart 10) and, while we are recommending to buy into strength, from a portfolio risk management perspective, today we are also setting a trailing stop at the 10% return mark in order to protect profits in this tactical (three-to-six month time horizon) position. Chart 10Buy Into Strength... Buy Into Strength... Buy Into Strength... These high-octane highly-cyclical tech stocks move in lockstep with other volatile asset classes. Rebounding emerging market (EM) stocks and FX confirm the S&P semi equipment breakout, and signal additional gains in the coming months (Chart 11). Not only do they share the high-beta status, but also semi equipment stocks garner 90% of their sales outside U.S. shores and 21% of total revenues come from China (please refer to Table 3 in our December 17, 2018 Weekly Report). Thus, the tight inverse correlation with the greenback and positive correlation with the outperforming EM stocks comes as no surprise (Chart 11). Chart 11...But Expect Heightened Vol ...But Expect Heightened Vol ...But Expect Heightened Vol Importantly, Taiwan and Korea are chip manufacturing hubs and semi equipment stocks are levered plays on the macro backdrops of these two economies. Recent data suggests that a turn is in the making in two key indicators in these countries, respectively. Taiwanese tech capex has likely troughed at a depressed level (middle panel. Chart 12), and Korean electronic components manufacturing capacity is now contracting for the first time since late-1997 (bottom panel, Chart 12). The latter is significant as this abrupt and sizable reining in of productive capacity will soon help arrest the fall in chip prices, which serves as an excellent pricing power proxy for the semi equipment industry. Chart 12Green Shoots Green Shoots Green Shoots Historically, relative forward profit growth and DRAM price momentum are joined at the hip. Therefore, were DRAM prices to exit deflation on the back of constrained Korean capacity, that would be a boon for relative profit prospects (second panel, Chart 13). Chart 13Analysts Have Thrown In The Towel Analysts Have Thrown In The Towel Analysts Have Thrown In The Towel Despite these marginal positive developments, sell-side analysts’ pessimism reigns supreme. Industry revenue and profit growth expectations trail the broad market by a wide margin and net EPS revisions remain as bad as they get. The upshot is that these lowered profit and sales growth bars will be easy to surpass in 2019 (Chart 13). With regard to technicals and valuations, oversold conditions bounced, as we posited in mid-December using history as a guide, but still remain depressed (middle panel, Chart 14). Valuations are compelling with the S&P semi equipment forward P/E trading at a roughly 40% discount to the overall market (fourth panel, Chart 13). Chart 14Technicals Remain Depressed Technicals Remain Depressed Technicals Remain Depressed Finally, earnings season has revealed that the bifurcated semiconductor market has staying power with semi equipment stocks (we are overweight) outperforming their ailing semi producer brethren (we remain underweight). Netting it out, sustained EM stock outperformance, a soft U.S. dollar, improving industry operating metrics, along with compelling relative valuations and technicals, all suggest that there are high odds that the recent semi equipment run up has more upside. Bottom Line: Maintain the overweight stance in the S&P semi equipment index for a while longer, but set a trailing stop at the 10% relative return mark in order to protect profits in this tactical (three-to-six month time horizon) position. The ticker symbols for the stocks in this index are: BLBG: S5SEEQ – AMAT, LRCX, KLAC.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. 2      Ibid. 3      Please see BCA U.S. Equity Strategy Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. 5      Please see Bloomberg Article, “PBOC Sets Up Swap Tool to Aid Bank Capital via Perpetual Bonds” dated January 24, 2019, available at www.bloomberg.com. 6      Please see BCA U.S. Equity Strategy Report, “Trader’s Paradise” dated January 28, 2019, available at uses.bcaresearch.com. 7      Please see BCA U.S. Equity Strategy Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

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. Is This The Bottom For Apple Is This The Bottom For Apple   1      Please see BCA U.S. Equity Strategy Weekly Report, “Trader’s Paradise” dated January 28, 2019, available at uses.bcaresearch.com.  

Highlights The Eurostoxx600’s short bursts of outperformance require either global technology to underperform or the euro to underperform. EM’s short bursts of outperformance usually coincide with the global healthcare sector’s short bursts of underperformance. Remain tactically overweight to Europe and EM, but expect to reverse position later in the year. The ECB is justified in setting an accommodative monetary policy, but it is not justified in setting an ultra-accommodative monetary policy. Soft inflation prints will cap the extent to which bond yields can rise in the near term. Italian BTPs are an attractive long-term proposition, especially relative to other euro area bonds. Feature Chart of the WeekEuro Area Inflation Appears To Be Underperforming... Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not ...But Adjusted For Its 'Negative Space' It Is Not Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not     “The music is not in the notes, but in the silence between”  – Wolfgang Amadeus Mozart As Mozart pointed out, true awareness lies not in appreciating what is there, but in appreciating what is not there. This is the concept of ‘negative space’: to understand an object, you have to understand the empty space that defines it. This week’s report extends the concept of negative space into the fields of investment and economics to make more sense of Europe’s recent past and its future. The Negative Space In Stock Markets Picking stock markets is a relative game. This means that what a stock market does not contain – its negative space – is often more important than what it does contain (Table I-1). This is not an abstract proposition, it is a mathematical truth. When a major global sector is strongly outperforming, a stock market’s zero or near-zero exposure to that sector will create a strong headwind to relative performance. And when the major sector is underperforming, its absence in the stock market will necessarily create a strong tailwind to relative performance. Chart I- For the European stock market, the negative space is technology, a sector in which European equities have a near-zero exposure. But there is another factor to consider: the currency. The technology sector’s global profits are mostly translated into shares quoted in dollars, while European equities’ global profits are mostly translated into shares quoted in euros. It follows that the Eurostoxx600’s short bursts of outperformance require at least one of the following two conditions (Chart I-2): Chart I-2The Eurostoxx600 Usually Outperforms When Technology Underperforms The Eurostoxx600 Outperforms When Technology Underperforms The Eurostoxx600 Outperforms When Technology Underperforms Technology to underperform. Or: The euro to underperform. For emerging market (EM) equities, the negative space is healthcare, a sector in which EM has a near-zero exposure. Therefore unsurprisingly, EM’s short bursts of outperformance usually coincide with the healthcare sector’s short bursts of underperformance (Chart I-3). Sceptics will raise an obvious question: what is the cause and what is the effect? The answer is that sometimes EM is the driver of healthcare relative performance, and at other times vice-versa. Chart I-3EM Usually Outperforms When Healthcare Underperforms EM Outperforms When Healthcare Underperforms EM Outperforms When Healthcare Underperforms A sharp slowdown emanating from emerging economies would undoubtedly drag down global equities. In the ensuing bear market, the more defensive healthcare sector would almost certainly outperform the financials. Under these circumstances the direction of causality would clearly be from EM to healthcare’s relative performance. On the other hand, absent a major bear market, in a common or garden reassessment of sector relative valuations versus their growth prospects, the causality would run in the other direction: sector rotation would drive the relative performance of equity markets: healthcare’s underperformance would help EM to outperform; and technology’s underperformance would help European equities to outperform. As we have explained in recent reports, the major sectors – and therefore the major stock markets – are now in this latter configuration in a brief countertrend burst before reverting to their structural trends later this year (Chart I-4 and Chart I-5). So for the time being, remain tactically overweight to Europe and to EM.1 Chart I-4The Eurostoxx600 Outperformance Is A Countertrend Burst The Eurostoxx600 Outperformance Is A Countertrend Burst The Eurostoxx600 Outperformance Is A Countertrend Burst Chart I-5The EM Outperformance Is A Countertrend Burst The EM Outperformance Is A Countertrend Burst The EM Outperformance Is A Countertrend Burst The Negative Space In European Inflation And Unemployment On the face of it, inflation is structurally underperforming in the euro area versus the U.S. But on closer examination this is only because of what the euro area harmonised index of consumer prices (HICP) does not contain: owner occupied housing costs – which tend to rise faster than other items in the price basket. Adjusting for this negative space in the HICP, the euro area and the U.S. have both achieved the exact same modest structural inflation, which their central banks define as ‘price stability’ (Chart of the Week).   In a similar vein, the unemployment rate disregards changes in the labour participation rate. When people join the labour force – as they are in their tens of millions in Europe (Chart I-6) – the joining cohort tends to have a slightly higher unemployment rate given its inexperience in the formal labour market. So the joiners tend to lift the overall unemployment rate too. The paradox is that the percentage of the working age (15-74) population in employment also rises at the same time. Looking at this alternative measure of labour market health, the euro area employment market is in a structural uptrend and much healthier than it was at the peak of the last cycle in 2008 (Chart I-7). Chart I-6Europeans Are Joining The Labour Force In Their Tens Of Millions Europeans Are Joining The Labour Force In Their Tens Of Millions Europeans Are Joining The Labour Force In Their Tens Of Millions   Chart I-7The European Employment To Population Ratio Is In A Structural Uptrend The European Employment To Population Ratio Is In A Structural Uptrend The European Employment To Population Ratio Is In A Structural Uptrend Hence, once we adjust for what is missing in euro area inflation and the euro area unemployment rate, neither inflation nor employment market performance appear to be too cold or too hot. This means that the ECB is justified in setting an accommodative monetary policy, but it is not justified in setting an ultra-accommodative monetary policy. The Negative Space In Monetary Policy The negative space in monetary policy is literally the negative space, by which we mean that interest rates cannot go deeply into negative territory. With the deposit rate already at -0.4 percent, the ECB’s room for manoeuvre in the dovish direction is limited. On the other hand, neither can monetary policy get meaningfully hawkish in the near term. The simple reason is that the ECB, like other central banks, is now even more wedded to ‘data-dependency’. The problem with this is that the data on which the central banks depend is always backward-looking. So policy will reflect what was happening one or two months ago, rather than what is happening now. Specifically, the plunge in the price of crude oil will depress both headline and core inflation rates (Chart I-8). And the recent wobble in risk-asset prices has weighed down some sentiment surveys (Chart I-9). Having promised to be data-dependent, the central banks have effectively created ‘an algorithm’ for their policy setting, an algorithm which everyone can see and read. It follows that the data, especially soft inflation prints, will cap the extent to which bond yields can rise in the near term. Chart I-8The Plunge In The Price Of Crude Will Subdue Inflation The Plunge In The Price Of Crude Will Subdue Inflation The Plunge In The Price Of Crude Will Subdue Inflation Chart I-9The Stock Market Sell-Off Hurt Sentiment The Stock Market Sell-Off Hurt Sentiment The Stock Market Sell-Off Hurt Sentiment However, core euro area bonds are an unattractive long-term proposition. When yields are so close to their lower bound, there is little scope for a capital gain, even in a crisis. Whereas the scope for a capital loss is considerably greater. By contrast, Italian BTPs are an attractive long-term proposition, especially relative to other euro area bonds. Almost all of the 2.75 percent yield on 10-year BTPs is a premium for euro break-up risk. Yet the populists in Italy do not want to break up the euro. And despite their rhetoric, neither do the populists in the core countries. To understand why, we must explain the negative space of ECB QE. When the ECB bought BTPs from Italian investors, what the Italian investors did not do was deposit the cash in Italian banks. Instead, they deposited it in German banks – something that we can see very clearly in the euro area’s mirror-image Target2 imbalances (Chart I-10). Chart I-10ECB QE Has Exacerbated The Target2 Imbalances ECB QE Has Exacerbated The Target2 Imbalances ECB QE Has Exacerbated The Target2 Imbalances In effect, the core countries, through their equity in the Eurosystem, are holding a huge quantity of Italy’s €2.7 trillion of BTPs. Meaning that if the euro broke up, the core countries would be the ones picking up the tab. For the euro area’s future, this is the most important negative space of all. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System* There are no new trades this week. But all four of our open trades – long PKR/INR, industrials versus utilities, litecoin and ethereum, and MIB versus Eurostoxx – are in profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 Please see the European Investment Strategy Weekly Report, “Why 2019 Is The Mirror-Image Of 2018”, dated January 10, 2019, available at eis.bcaresearch.com. Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

  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. Chinese Sales Fall Flat For Apple Chinese Sales Fall Flat For Apple  

Semi Equipment - Enough Is Enough Semi Equipment - Enough Is Enough Overweight In this week’s Weekly Report, we highlight three macro factors that, should they sustain their recent trajectories, would serve to catalyze the semi equipment group. First, trade policy uncertainty has dealt a blow to this tech subindex (trade policy uncertainty shown inverted, top panel). Not only are 90% of sales foreign sourced, but a large chunk is also China-related sales. Second, emerging market manufacturing PMIs are showing some signs of life, underscoring that semi equipment demand may turn out to be marginally less grim than currently anticipated (second panel). Third, while global semi sales will continue to decelerate for the next three-to-six months, the semi market is functioning as if the inventory liquidation cycle is in the later innings (third and bottom panel). Net, we think the drubbing in the S&P semi equipment index is overdone and even a modest improvement on either the trade policy, industry demand or currency fronts could result in a reflex rebound. Bottom Line: We lifted the S&P semi equipment index from underweight to overweight on Monday, as a tactical move for the next three-to-six months; please see Monday’s Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5SEEQ – AMAT, LRCX and KLAC.

Highlights Portfolio Strategy The drubbing in the S&P semi equipment index is overdone and even a modest improvement on either the trade policy, industry demand or currency fronts could result in a reflex rebound, warranting an above benchmark allocation. An oil price rebound on the back of a more balanced supply/demand backdrop, a continuation in the global capex energy upcycle and compelling relative valuations all suggest that the path of least resistance is higher for oil majors. Recent Changes Boost the S&P Semiconductor Equipment index to overweight today, on a tactical three-to-six month time horizon. Table 1 Signal Vs. Noise Signal Vs. Noise Feature Equities attempted to stage a recovery last week and are in a triple bottom technical formation, still consolidating the October tremor. The Fed meeting later this week will likely prove a catalyst on the monetary policy front, especially if the closely watched FOMC median dots decrease for 2019 as the bond market has been expecting. As we mentioned in our 2019 High-Conviction calls Report two weeks ago,1 the Fed will dominate markets next year and any dovish change in interest rate expectations will breathe a sigh of relief into the SPX. Given the heightened volatility and violent recent equity market oscillations, it is important to separate the noise from the actual signal. While distinguishing between the two is hard at times, we are relying on a few key indicators to aid us in this process. First, our S&P 500 EPS growth model is still expanding near the 10% mark for next year as clearly 25% EPS growth is not sustainable. While the risk is that this growth rate decelerates further, as long as EPS do not contract next year, stock prices should recover (Chart 1). From a macro perspective, at this stage of the cycle with nominal GDP growth between 4-5%, organic EPS growth should at least mimic nominal output growth. Tack on a 2% buyback yield or artificial EPS growth and attaining a 7% EPS growth rate is likely next year. Chart 1 Second, while the 5/2 and 5/3 yield curve slopes have inverted and we heed these signals, the 10/2 and the Fed’s spread (2-year yield minus the fed funds rate) have yet to invert. Historically, the most significant yield curve signals for the equity market are when simultaneously all the different yield curve slopes are inverted. While everyone is infatuated with the yield curve inversion implications of recession, we are laser focused on the interplay between the yield curve and stock market peaks. Importantly, typically the 10/2 yield curve inversion occurs before stock market peaks. Going back to the mid-1960s there has been only one time when the stock market peaked prior to the yield curve inversion, in 1973: the SPX crested on January 11 and the yield curve inverted on January 16 (due to lack of data we use the effective fed funds rate instead of the 2-year yield prior to 1976). In all the other iterations, the yield curve inverts prior to the stock market top. Even in 1998 the yield curve inverted in late-May and the SPX peaked in mid-July before suffering a 20% drawdown. Similarly, on February 2, 2000 the yield curve inverted and on March 24, 2000 the SPX topped out for the cycle. Chart 2 Chart 3… And Then The SPX Peaks ...And Then The SPX Peaks ...And Then The SPX Peaks In other words, the yield curve inversion is a leading indicator and once the curve inverts, it signals that the stock market highpoint will follow soon thereafter (Charts 2 & 3). The broad market tops on average 248 days (median 77 days) following the yield curve inversion (Table 2), though the large variability in each iteration limits the usefulness of this average as an accurate predictor. Nevertheless, the implication remains that the SPX has yet to peak for the cycle. Table 2Yield Curve Inversions And S&P 500 Peaks Signal Vs. Noise Signal Vs. Noise Third, a slew of economically sensitive indicators have troughed. Sweden’s PMI and Swedish stock market relative performance have been in a V-shaped recovery. As we highlighted earlier this week,2 Sweden is a small open economy and it is likely sniffing out an improvement in global export volume growth and a likely de-escalation in the U.S./China trade tussle. EM FX, the CRB raw industrials commodities index, the Baltic Dry Index and semi equipment stocks (see more details in the next section) all suggest that the worst is over, and global trade will likely resume its advance in the coming months (Chart 4). Chart 4Hyper-sensitive Indicators Sniffing Out A Trough? Hyper-sensitive Indicators Sniffing Out A Trough? Hyper-sensitive Indicators Sniffing Out A Trough? Finally, inflation is coming off the boil and will likely decelerate in the months ahead courtesy of the fall in WTI crude oil prices. Were oil to move sideways from here, headline inflation would decelerate further, likely overwhelming core CPI (Chart 5). This is significant, as it could serve as a monetary policy catalyst. Put differently, decelerating inflation may cause the Fed to reconsider the pace of its interest rate hikes. A pause in the tightening cycle in March 2019 would be a welcome development for stocks, especially if the fed funds rate is nearing the terminal rate as we recently highlighted in our trough-to-peak fed funds rate tightening cycle analysis.3 Chart 5Inflation Will Decelerate Inflation Will Decelerate Inflation Will Decelerate Adding it all up, our still expanding SPX EPS growth model, a lack of a 10/2 yield curve inversion, a trough in a number of economically sensitive indicators and the potential for a temporary Fed hike pause in March next year, all signal that the equity bull market is not over and fresh all-time highs are looming in 2019. This week we are upgrading, on a tactical basis, a bombed out tech subgroup, and updating our view on a deep cyclical index. Semi Equipment: Enough Is Enough We are lifting exposure in the niche S&P semi equipment index from underweight to a modest overweight. Putting this in perspective, this small index comprises only 1.5% of the tech universe and commands a mere 0.3% weight in the S&P 500. There are high odds that most of the carnage in semi equipment stocks is already reflected in the violent swing of the sell side community from extreme bullishness up until August of this year to the current extreme bearishness. As a reminder, the S&P semi equipment index was part of U.S. Equity Strategy’s high-conviction underweight call revealed in November 27, 2017 when the sell-side could not have enough of semi equipment stocks as analysts were also mesmerized last winter by the near $20,000/bitcoin related mania.4 This timing coincided with the peak in performance of this hypersensitive early-cyclical tech index (Chart 6). Chart 6Extreme Bearishness... Extreme Bearishness... Extreme Bearishness... To get a sense of how far the pendulum has swung on the bearish camp, we note the following: The relative 12-month forward EPS growth has deflated from positive 60% to negative 20% (Chart 6). The index’s forward P/E is trading at a 40% discount to the SPX, relative 5-year EPS growth estimates are near previous troughs and even compared to the overall tech sector; semi equipment long-term EPS growth is now forecast to trail their tech brethren (Chart 7). Even forward sales growth has collapsed, falling to a multi-year low. Analysts now expect an outright contraction in revenues to the tune of 4% or 10 percentage points below the S&P 500 (Chart 6). Net EPS revisions have also been sinking like a stone, approaching the 2012 nadir (Chart 6). Technical conditions are oversold with cyclical momentum as bad as it gets (Chart 7).  Chart 7...Reigns ...Reigns ...Reigns Beyond this overly pessimistic backdrop, there are some macro indicators that, were they to sustain their recent budding recoveries, would serve to catalyze the chip equipment group. First, trade policy uncertainty has dealt a blow to this tech subindex (trade policy uncertainty shown inverted, top panel, Chart 8). Not only are 90% of sales foreign sourced, but a large chunk is also China-related sales. Table 3 highlights the excessive sensitivity these stocks have to the U.S. dollar. In fact, the correlation with J.P. Morgan’s EM FX index is an almost perfect one (Chart 8). If President Trump is serious about striking a deal with China, then this group would enjoy a relief rally. Chart 8Potential Positive Catalysts Potential Positive Catalysts Potential Positive Catalysts Table 3U.S. Semi Equipment Geographical Sales Breakdown Signal Vs. Noise Signal Vs. Noise Second, emerging market manufacturing PMIs are showing some signs of life, underscoring that semi equipment demand may turn out to be marginally less grim than currently anticipated (Chart 9). Chart 9EM Green Shoots? EM Green Shoots? EM Green Shoots? Third, while global semi sales will continue to decelerate for the next three-to-six months, the semi market is functioning as if the inventory liquidation cycle is in the later innings, with our industry pricing power proxy plummeting 180 percentage points from peak-to-the-recent trough, just below the contraction zone (Chart 10). Chart 10Inventory Liquidation Is In Late Stages Inventory Liquidation Is In Late Stages Inventory Liquidation Is In Late Stages Finally, any bounce in cryptocurrencies may also serve as a positive catalyst for additional demand for the semi equipment companies that enjoy monopolies in their respective manufacturing niches (Chart 10). In sum, the drubbing in the S&P semi equipment index is overdone and even a modest improvement on either the trade policy, industry demand or currency fronts could result in a reflex rebound. Bottom Line: Lift the S&P semi equipment index from underweight to overweight today, as a tactical move for the next three-to-six months. The ticker symbols for the stocks in this index are: BLBG: S5SEEQ – AMAT, LRCX and KLAC. Oil Majors Are Holding Firm In early-February we upgraded the heavyweight integrated oil & gas energy subindex to an above benchmark allocation. Our thesis centered on a capex upcycle recovery and firming oil price backdrop that would unlock excellent value in this key energy subgroup. Since then, the relative share price ratio has moved laterally. Interestingly, this defensive energy subindex neither kept up with the steep oil price advance until the end of September, nor with the recent drubbing in crude oil prices (Chart 11). Put differently, oil majors never discounted sustainably higher oil prices, and are also refraining from extrapolating recent oil prices weakness far into the future. Chart 11Defensive Oil Equities Defensive Oil Equities Defensive Oil Equities While the Trump Administration’s flip-flop on the Iranian sanctions has injected extreme volatility into oil prices, some semblance of normality has returned to the crude oil markets as last week OPEC and Russia agreed to a production cut in order to help balance the market. Another key factor that has contributed to the recent fall in oil prices at the margin has been U.S. shale oil supplies. Roughly 30% per annum growth in U.S. crude oil production is unsustainable and, were production to remain near all-time highs and move sideways in 2019, then the growth rate would fall back to the zero line. Such a paring back in the growth rate, along with OPEC/Russia discipline, would likely balance the oil market and pave the way for an oil price recovery (oil production shown inverted, Chart 12).   Chart 12U.S. Supply Response Is Looming U.S. Supply Response Is Looming U.S. Supply Response Is Looming Given that BCA’s Commodity & Energy Strategy service continues to forecast higher oil prices into 2019, the S&P integrated oil & gas index should stage a sustainable rebound next year. While the recent swift drop in oil prices is jeopardizing the still recovering capital expenditure cycle, we doubt $50/bbl oil would make current projects uneconomical and result in mothballing or outright canceling of ongoing oil exploration projects (Chart 13). Granted, a big assumption is that oil prices at least hold near the current level and do not suffer a relapse to the early-2016 lows. Historically, rising oil exploration outlays and integrated oil & gas share prices move in lock step and the current message is to expect a rebound in the latter (Chart 14). Chart 13Low Odds Of A Total... Low Odds Of A Total... Low Odds Of A Total... Chart 14...Capex Collapse ...Capex Collapse ...Capex Collapse Finally, sell-side analysts are throwing in the towel. Net earnings revisions have taken a beating of late, which is positive from a contrary point of view (second panel, Chart 15). Relative valuations are extremely compelling on a number of metrics including relative price-to-book, price-to-sales and relative forward price-to-earnings (third panel, Chart 15). Tack on a near 200bps positive delta in the dividend yield versus the broad market and yield hungry investors will also seek the relative safety of this defensive energy subindex (bottom panel, Chart 15). Chart 15Integrated Stocks Are On Sale Integrated Stocks Are On Sale Integrated Stocks Are On Sale Netting it all out, an oil price rebound on the back of a more balanced supply/demand backdrop, a continuation in the global capex energy upcycle and compelling relative valuations all suggest that the path of least resistance is higher for oil majors. Bottom Line: Stay overweight the heavyweight S&P integrated oil & gas energy subindex. The ticker symbols for the stocks in this index are: BLBG: S5IOIL – XOM, CVX and OXY. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “2019 Key Views: High-Conviction Calls,” dated December 3, 2018, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Sector Insights, “Can Sweden Lead The SPX?” dated December 12, 2018, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “2019 Key Views: High-Conviction Calls,” dated December 3, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Weekly Report, “2018 High-Conviction Calls,” dated November 27, 2017, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps