With the Nasdaq up more than 67% since March, some fund managers are taking profits on their tech holdings and rotating into other cyclical stocks
While there are still reasons to be wary of how far equity prices have come since March, those who are certain the rally can be sustained are trying to position their portfolios for the biggest possible gains in the months ahead, and that may mean shifting away from technology stocks.
Technology has been the most-loved sector since the stock market hit its low in March, evidenced by the fact that the 67.4% gain in the Nasdaq composite index since then has far outpaced the 57% rise in the Standard & Poor's 500-stock index and the 49% increase in the Dow Jones industrial average. The reason that tech stocks didn't drop as sharply as financials or industrials when the broader market cratered supposedly is because businesses were expected to continue to spend on technology products to improve efficiency even as they slashed their workforces and cut other costs.
But with tech stocks having come so far, and confidence about a sustained rally wavering, some mutual fund managers have begun to trim their tech holdings to move more aggressively into other sectors they think may have more leverage to the economic recovery. Standard & Poor's Equity Research had an overweight position in tech from Mar. 24, but downgraded the sector on July 31 to market weight, says Alec Young, international equity strategist at the S&P research arm.
"We have a cyclical tilt. We think the [U.S.] economy will continue to recover," he says. "It may not be the best recovery, but it's all the market needs to keep going up." S&P is recommending an overweight position in energy, industrials, and materials.
favoring industrials and financials
Optimum Investment Advisors, the Chicago-based subadvisor to the Aston Optimum Large-Cap Opportunity Fund (AOLCX), was 30% overweight in tech stocks until July, when it began to gradually rotate into financials and industrials, which had taken a bigger beating than tech during the downturn.
Signs of a broader economic recovery in late June convinced Optimum to be less defensive. While tech isn't typically considered defensive, the fact that it didn't drop as sharply during the downturn made it seem the safest of the cyclical industries, says Steven Sherman, research director for the Large Cap Opportunity Fund and the large-cap product at Optimum.
Optimum now has a neutral position in tech and has gone from underweight to overweight in industrials and financials.
"We're trying to add to our credit sensitivity. A better economic environment will lead to faster recovery for [banks that] have made loans than most currently have had,"says Sherman. That means adding credit-card companies such as American Express (AXP) and looking for the most undervalued regional banks, those hit hardest but with the most growth potential.
engineering and construction promise
"We're trying to focus on banks that have reserved [cash for potential losses on bad loans] relatively effectively and where the market is still beating them up significantly," says Sherman. "From a recovery perspective, if we're in a better economic environment next year from today, these banks will look an awful lot better."
As for industrials, Optimum sees opportunity in engineering and construction companies such as Fluor (FLR) and Jacobs Engineering (JEC), stocks whose share prices fell later in the economic cycle and haven't participated as much in the recovery to date. "They had large backlogs of business, so they didn't dip quite as fast. They're seeing a little more deterioration now than some of the other companies," says Sherman. "Because of the shape of the boom of business, it hits their income statements a little later. We're investing based on where these businesses will be a year to a year and a half from now."
If the economy continues to gain traction, fund managers and investors will gravitate to the sectors where they see the most earnings growth—financials, industrials, and materials, says David Bianco, chief U.S. equity strategist at Bank of America (BAC). Higher exports will boost earnings for industrials and materials companies, while declining loan loss provisions, which have been a big drain on financials' earnings, will help bolster profits for companies in that sector.
"You already see a lot of movement into financials, not necessarily at the expense of tech," says Bianco. "Tech has a strong secular leadership due to its global exposure, but over the last couple weeks we've seen stronger gains in financials than tech stocks." While he expects bigger gains for financials than for tech stocks over the next 6 to 12 months, both sectors will continue to outperform the broad market, he adds.
a case for fixed income
While lower credit costs, higher oil prices, and healthy demand from foreign markets will all contribute, financials will be the biggest driver of the recovery in earnings for the S&P 500, which will outpace the recovery in U.S. [gross domestic product], Bianco wrote in a Bank of America research report on Sept. 8. "Subdued GDP growth supports a long-lasting, steep yield curve. This is a much greater benefit to banks than a rapid U.S. recovery," he wrote.
The acquisition of one of Ivy Mid Cap Growth Fund's (WMGAX) holdings—a data services company, one-third of whose shares the fund owned — is the only reason the fund recently reduced its technology position to neutral after having been overweight for much of the first half of this year. But at Waddell & Reed, portfolio manager Kim Scott says she's more inclined to add to her tech exposure than trim it further because technology takes advantage of a broad swatch of the economy, from consumers who will continue to buy "cool stuff that works better" to businesses looking to boost efficiency.
"All kinds of technology was put in place that really helped [a wide variety of companies across the world] respond much more quickly than they have ever been able to respond to an economic downturn," she says. "The benefit of technology has been proven out in this recession, and I don't think companies will hesitate to optimize their use of technology" in the future.
She has increased her fund's exposure to industrial stocks since the equities rally began, but even in that sector she has picked names with a strong technology component to their product platform. Two examples: Kaydon (KDN), which makes large bearings for windmills, and Quanta Services (PWR), which consults on engineering and construction projects for power utilities.
She doesn't expect the market's preoccupation with more beaten-up sectors to last. "It's going to get to the point in this recovery where you have to stop looking at high-beta, left-for-dead companies and look at companies that are really going to grow [earnings once] an economic recovery is strongly in place," she says.
Portfolio Management Consultants (PMC), a Los Angeles-based company that offers 13 tactical portfolios to its network of financial advisers, takes a more dubious view of the rally in equities and recommends sticking to fixed income until there are more conclusive signs that the risk/reward prospect for stocks has improved. From a technical investing perspective, when stock valuations are 20% ahead of the 200-day moving average for the S&P 500, as they are now, it has indicated an overbought condition, says Richard Hughes, co-president of PMC. When that's happened before, however, the rally has sometimes continued for several more months in spite of the overbought signal, he adds.
PMC's model shows that consumer staples, information technology, and, to a lesser extent, energy, are the most positive sectors that will be the first to warrant a switch from fixed income to equities.
For those more optimistic about a U.S. recovery, it may be time to take some chips off tech and spread their bets to the rest of the table.