Top 2 Stock Plays Ahead of Big Tech Earnings Announcements

“The only constant is change.”

— Heraclitus of Ephesus

Heraclitus’ observation is my personal motto.

It informs my attitude to the stock market … and you’d be wise to adopt it as well.

As a historian, I shake my head at people who assume things can continue as they are indefinitely.

That’s never happened in recorded history.

That’s especially true of the stock market.

Twice in the last 30 years, we’ve seen a massive rotation from one segment of the stock market to another.

In the run-up to the dot-com collapse in 2000, technology stocks were all the rage. But for the three years after the bubble burst, small-cap value ruled the roost:

The pattern reversed after the Great Financial Crisis of 2008-2009 (GFC). Technology stocks rocketed away from the rest of the market.

Today the top five technology stocks in the S&P 500 Index — Facebook Inc. (Nasdaq: FB), Apple Inc. (Nasdaq: AAPL), Amazon.com Inc. (Nasdaq: AMZN) and Alphabet Inc. (Nasdaq: GOOGL) — represent almost 23% of its value. That’s the highest concentration of value in the top five stocks ever.

Many investors assume this will continue indefinitely.

But they should heed Heraclitus’ warning … and look for the next big change.

The Winds of Change

The six largest technology stocks in the U.S. today — the five above plus Netflix Inc. (Nasdaq: NFLX) — have appreciated by over 3,700% since the GFC. They’ve added another 33% just since the beginning of this year.

By contrast, the S&P 500 Index as a whole is struggling to break even on the year. Without the big six, it would be down substantially.

This outstanding run has convinced many investors to build their portfolios around Big Tech. But that could prove costly, given the storm clouds gathering on the horizon.

All the big companies are currently priced well above the average price-to-earnings ratio for the S&P 500 Index, which is around 26. Amazon’s is 146. Those premium valuations are based on expectations of future growth, as has long been the case.

But there are four less visible elements in Big Tech’s outperformance that suggest change could be on the way. Let’s consider them.

No. 1: Big Tech has become a victim of its own success.

Many institutional portfolio managers, especially in pension and mutual funds, are not permitted to hold more than 5% of their portfolio in any one stock. All the Big Tech stocks are pushing those limits right now, which suggests that institutional demand for their shares will soon decline.

No. 2: The Big Tech stocks have grown to dominance in a historically weak economic environment, which helped to boost their returns.

Annual U.S. gross domestic product growth over the last decade has averaged around 2%, compared to 4% in the ‘80s and ‘90s and over 5% in the period after the Second World War. The resulting flat performance of real-world companies has made low-capital, high-margin Big Tech companies attractive by comparison, helping to push their prices up as investors have sought better returns.

No. 3: Amid the COVID-19 crisis, the price differential between Big Tech and the rest of the stock market has become extreme.

If these stocks fail to maintain their momentum for any reason, that will quickly drag down the entire stock market. Investors will pull their money out and move into bonds or gold, putting further downward pressure on prices, including the Big Tech companies themselves.

No. 4: All of these companies are facing intense regulatory scrutiny for their monopolistic power. Authorities in the U.S. and Europe are becoming increasingly concerned that their market and financial power is distorting not only the stock market and the economy, but political life as well.

The top executives from Facebook, Amazon, Apple and Alphabet will all be testifying about these antitrust issues on Wednesday — the day before those four report earnings.

The Paradox of Bigness

These factors suggest that Big Tech’s run may come to an end sooner than many investors expect.

But there’s an important paradox at work here … one that could lead to big profits if you position yourself correctly.

I noted above that the largest technology stocks have benefited from the relatively weak performance of the real economy over the last decade. Companies selling physical products into a weak market weren’t as attractive to investors.

But with interest rates at historical lows, those investors wanted to buy stocks … and Big Tech was there waiting for them.

The paradox is that if the economy begins to recover, we will likely see a rotation away from these growth stocks toward cyclical value stocks that have been neglected for years. That could lead to a reversal in the relative performance of the two market segments.

This is precisely what happened at the end of last week, when sharp drops in the Big Tech names sent the SPDR S&P 500 ETF Trust (SPY) down 1.19%, while the Invesco S&P 500 Equal Weight ETF (RSP) was off just 0.16%:

Get Ready for the Reversal

The basic setup here is that one sector of the stock market — growth-oriented Big Tech — is nearing the upper limits of its long run. It’s opposite — value-oriented mid and small caps — are trading at bargain prices and poised to recover strongly if and when the economy rebounds.

Under these circumstances, a savvy investor might want to put some money into exchange-traded funds (ETFs) like the Vanguard Value ETF (NYSE: VTV) or the iShares S&P Small-Cap 600 Value ETF (NYSE: IJS) to pre-position for upcoming rotation toward the sectors. The likely gains will be much higher than those for already extended growth stocks.

That could happen a lot sooner than anyone realizes. Most of the Big Tech stocks report earnings this week. That means rotation could begin almost immediately.

Whatever you do, don’t rest your laurels — or your money — on what has gone before.

Heraclitus could tell you why.

Kind regards,

Ted Bauman

Editor, The Bauman Letter