I believe we are in a passive investing “bubble”, where investors have been blindly buying large cap equities, irrespective of valuation, because they were “big”. There’s no greater example of this than in the big five technology stocks in the USA.
In the year-to-date, just five large technology stocks have accounted for 41% of the gain in S&P500 Index market capitalisation. That is unprecedented but so too are flows into passive products (index funds and ETFs) which have been driving those gains.
The five stocks are Apple, Amazon, Facebook, Microsoft and Alphabet (parent of Google). However, late last week we saw what is the start of some profit taking emerge in these mega-cap US technology stocks. Again, it reminded you that there is NO capital protection in owning what everyone else owns, particularly at such extremes of valuation and positioning.
By positioning, I mean the broad level of ownership and it would be fair to say these big five US technology stocks have NEVER been more widely owned by all styles of investors.
But when momentum changes, the problem with extreme long positioning is there isn’t a marginal buyer. In fact, the momentum change brings out marginal sellers and the stocks in question hit an “air pocket”.
The fact the dominance of the big five technology stocks in the US has been so large most likely suggests this profit taking pressure/rotation to value stocks will not be a one-day event. This has every chance of being a medium-term event, which will trigger a genuine correction in the big five technology names.
As I have written about before, the greatest potential downside lies in the biggest company in the world, Apple (APPL). APPL has been the biggest beneficiary of the passive bubble in terms of P/E re-rating, driven simply by its current position as the biggest stock in the biggest market in the world.
To remind you, APPL is an $800b market capitalisation stock. APPL is the largest weighting S&P500 (3.77%), Dow Jones Industrial Average (4.82%) and NASDAQ Composite (8.43%). APPL therefore attracts more passive dollars on a daily basis than any other stock on the planet. That’s all good until that passive flow reverses, because the P/E expansion it drove can’t be justified by earnings.
Make no mistake, APPL is a solid company, but its move this year is utterly unjustified on fundamentals. The stock has added $240b in market cap and is up +29% year to date. APPL is simply NOT a $240b better business than it was on January 1.
Its size has been a self-fulfilling, virtuous circle, to the point where I now believe Apple is overvalued and vulnerable to a genuine correction.
Similarly, as is always the case, analysts have found APPL’s share price rally too hard to fight and there are now 36 buy recommendations, 10 hold recommendations and 0 sell recommendations. The consensus 12-month price target is $164. That is a contrarian signal in itself.
Apple’s earnings last quarter were lower than Wall Street expectations and led to consensus earnings downgrades. Margins are not as good as expected and I personally believe we are at “peak smartphone” and smartphones will start being priced more like a commodity. I suspect most of us have had the same smartphone for a few years now. The difference is we are all using Amazon, Netflix, Uber, Google and Facebook more from them.
Just like telcos have become a “commodity”, as you can see all around the world and in Australia (TLS, VOC, TPM, etc.), I believe smartphone makers are next. Remember when Nokia and Blackberry were big companies? Technology is a cycle and I reckon the smartphone cycle is peaking. That is another reason I am cautious on Apple and Samsung.
It also seems there is now growing caution about the next iPhone sales cycle. While some point to APPL’s growing recurring revenue “ecosystem”, I am strongly of the view that it’s new product sales that drive APPL’s share price and they are struggling to find that blockbuster new product. It won’t be that new speaker they launched last week, that is for sure.
One of the reasons for some of the recent profit taking in APPL is simply based on product reviews that suggest the new iPhone is inferior to the new Samsung Galaxy smartphone.
According to Consumer Reports, the Samsung Galaxy S8 and Galaxy S8+ are the two best smartphones on the market. The two Samsung devices came in well ahead of Apple’s iPhone 7 and iPhone 7 Plus.
The products rating publication praised the bright and colourful displays of Samsung’s smartphones, while adding that both provide above-average battery life and “stunning” cameras.
Consumer Reports also found that Samsung’s phones were better able to withstand drops into its pressurised dunk tank, mean consumers won’t have to fret too much if a phone falls into water.
The point is that APPL doesn’t have the clearly superior product in smartphones anymore: the rest of the sector is catching up and, in part, exceeding Apple’s product. This is at the point of smartphone saturation in the western world, while in China, where smartphone adoption remains very strong, the Apple brand is not dominant.
This again reminds me that owning the device makers is a cyclical trade. What you want to own are the platforms who benefit from the advances in these mobile devices. The charts below confirm the major effect (+$240b in market cap) passive buying has had on Apple this year to date.
APPL vs EPS CY17 (red line)
The chart above shows APPL’s share price (white line) against consensus FY17 EPS (red line). While APPL consensus EPS has been falling over the last six months, the stock price has risen >45%. What that translates to is P/E expansion. APPL’s P/E has moved from around 10.5 to around 17x over the last 12 months. It’s basically gone from value to overvalued, driven by unprecedented passive flows.
APPL P/E CY 17
In my career, I can remember many similar events to this. Do you remember when News Corporation (NWS) was the biggest weighting in the ASX200 at the peak of the .com boom? Do you remember when BHP Billiton peaked at 10% of the ASX200 at the peak of the commodity boom? Do you also remember what happened next?
I feel Apple is exactly the same now, the stock being most distorted by passive flows anywhere in the world at what could prove to be the peak of its earnings growth cycle.
If nothing else, recent weakness in APPL shares remind you this stock can actually fall. If I am right and bond yields rise over the 2H of 2017, then I am certain APPL and the other big five US technology stocks will underperform cyclical sectors but financials in particular.
The other side of the APPL/tech rotation is financials and we even saw that in Australia on Tuesday where a long overdue bounce in banks lifted the ASX200 by nearly +100 points. That bank rally in Australia was driven by a global bank rally.
Below shows the year-to-date performance of APPL vs the ASX200 Banks Index in raw terms. This gap can potentially close further.
I know there’s plenty of cheerleaders for Apple out there, but my view is APPL around US$150.00 is overvalued. I see far better value elsewhere and APPL as a poor risk vs reward proposition at current prices. If APPL fell to around US$115.00, I would reconsider my cautious stance. Until that happens, APPL remains grossly over-owned and expensive versus its fundamentals. It’s also the greatest stock at risk of rotational selling, as we have seen in recent days. It’s also the greatest stock at risk if passive flows reverse.
APPL could be about to become a victim of its own success in what is a clear passive bubble. If you take profits in APPL, I’d be looking to redeploy the proceeds to global financials and China consumer-facing companies, including Chinese tech companies, into any pullback.
The AIM Global High Conviction Fund has taken profits in ALL US Technology stocks except JD.COM. We have rotated to European, UK, US and Chinese financials, feeling the risk/reward equation is far more in favour of reward in those sectors.
You will never overtake anyone driving in the same lane … If you own APPL, you’re in a traffic jam.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
