Technology

S&P communications equipment greenshoots are turning into full blossom, signaling additional share price outperformance ahead. The latest Federal Reserve industrial production (IP) release highlighted that telecom equipment factories are revving their engines, in contrast with muted overall output growth. Historically, industry IP growth has been closely correlated with shipments-to-inventories momentum and the current message is positive (second panel). Output is booming relative to capacity, inventories are lean and telecom equipment imports are subdued, which is supportive of pricing power. All of this is boosting our industry productivity proxy (third panel). The upshot is that S&P communications equipment profits will outperform the S&P 500, serving as a catalyst for a relative valuation re-rating phase (bottom panel). Bottom line: While we are underweight the broad tech sector, we are reiterating our early-August high-conviction overweight stance in the S&P communications sub-group. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV. bca.uses_in_2016_09_09_001_c1 bca.uses_in_2016_09_09_001_c1

We took profits in the S&P software index and downgraded to neutral in January, because the boost to corporate software investment to offset flagging productivity growth looked to have been fully discounted. After a six month consolidation, relative performance has jumped back to this year's highs, but the conditions to sustain a breakout are absent. Software demand is more levered to business investment than consumer spending. In the macro environment we envision, consumption will continue to outpace investment. The rise in the personal savings rate means that there is pent-up consumer spending to be realized as wage inflation recovers. On the flipside, stretched corporate balance sheets and a dearth of sales growth pose significant restrictions to capital spending budgets. Ominously, software sales are already contracting relative to total S&P 500 sales. The software industry's contribution to GDP growth invariably becomes negative, i.e. a drag, when overall capital spending retrenches, as is currently the case. Sales contraction, and profit margin erosion, is not conducive to premium valuations. Cut to underweight and please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG-S5SOFT: ADBE, ADSK, CA, CTXS, EA, INTU, MSFT, ORCL, RHT, CRM, SYMC, ATVI. bca.uses_in_2016_08_30_001_c1 bca.uses_in_2016_08_30_001_c1

The equity rally has been in a holding pattern, with some tactical fraying around the edges.

A technical breakout in communications equipment relative performance is being fundamentally-driven. New orders for communications equipment have perked up, led by a re-acceleration in telecom services capital spending (second panel). The telecom service sector has enjoyed the strongest revenue growth of all sectors this quarter, and free cash flow is growing at a mid-teens rate (middle panel). That is driving a pickup in investment, a positive omen for equipment demand. In addition, there is pent-up demand for communications gear following more than a decade of underinvestment. Even telecom equipment exports have recovered, signaling an undercurrent of global demand in an otherwise lackluster world economy. This is powering double-digit sales gains. That is translating into solid output growth and rising productivity. The implication is that dirt cheap valuations are primed for a re-rating, and we moved this group onto our high-conviction overweight list in yesterday's Weekly Report. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV. bca.uses_in_2016_08_09_002_c1 bca.uses_in_2016_08_09_002_c1

Despite our reservations about the broad tech sector, which has bounced under the leadership of only a handful of stocks, we are encouraged by the outlook for the communications equipment sub-component. This extremely undervalued group is enjoying a broad-based technical breakout, based on fundamental improvements. Our industry relative advance/decline line has touched new highs at the same time that the share price ratio has broken decisively above its multiyear downward sloping trend-line on an upsurge in momentum. That alone is indicative of a major trend change, a view that is driven by positive macro forces, please see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV. bca.uses_in_2016_08_09_001_c1 bca.uses_in_2016_08_09_001_c1

A two-speed economy requires selective portfolio construction, favoring consumer-oriented and mainly non-cyclical industries. Put communications equipment on the high-conviction overweight list, and stay clear of refiners.

In successful investment analysis "less is more, and usually much more effective."

The breakout in the S&P 500 could boost flows to EM, and momentum could overwhelm fundamentals for several weeks. Nevertheless, U.S. interest rate expectations will rise and it, along with weak EM profits, will cap upside in EM risk assets. Take profits on our short EM stocks/long 30-year U.S. Treasurys position. Reduce short exposure to EM currencies by closing the currency trades where the long side is partially against the yen.

Our <i>Cyclical Indicator Update</i> reveals that a defensive portfolio strategy remains the best bet to navigate the crosscurrents of stagnant profit/economic growth yet abundant global liquidity.