on Tuesday, 13 June 2017. Posted in 2017, June


Chicken Little; Short Seller

“The sky is falling.”

                       Chicken Little


The selloff that began in technology stocks on Friday and continued through Monday has elicited a broad range of opinions from market strategists.  Those negative on the market seized on the idea that it is a drawdown of the FANG+AAPL+MSFT that is long overdue.  The real bears are not stopping at technology, they believe this trend will broaden beyond to other sectors and expose the “weakening economy and the slowing earnings growth.”  Permabears are already stepping forward to claim the title “I told you so.”  Seems to lack as much credibility after 10 years as Chicken Little did claiming the “sky is falling.”  The conditions initiating the Tech selloff began after noted “activist short-seller” Andrew Left issued a report on chip maker Nividia (NVDA), concluding overvaluation as the primary reason that the chip stocks would go down.  He shorts the stock prior to the report released through his firm Citron Research.  No doubt by conventional fundamentals, NVDA carries a lofty P/E (41.1X), along with a 238% price appreciation over the past year and 50% over the past three months.  Whether the argument on value is valid has little to do with the trade.  Left already alerted other short sellers after taking his position.  For those who missed his call, he had an exclusive interview on CNBC’s “Half-Time Report” on Friday.  By the close, NVDA was down 10%.     
This was not Left’s first report on NVDA overvaluation.  In December 2016 he predicted the stock to fall at $90, but it rose to a high of $165. Persistence, capital, and in Left’s, case broad media exposure, are the tools of his trade.  The fact he has made some credible calls on questionable company practices does not always spill over into valuation calls.  But timing is everything.  The Citron report follows Citi, Merrill Lynch and UBS, raising target prices up to the $180’s over the past few days as their previous targets were surpassed.  As mentioned on these pages many times, 85% of hedge fund money is with 5% of the managers.  With about 8,000 hedge funds, that leaves 7,600 managers competing for 15% of the remainder.  Many of these funds are trading firms, including algorithmic and flash traders.  These funds trading long and short and accentuate the movement in both directions.  Performance under these circumstances requires quick moves, getting in early and out before a turnaround.  Smart money has already been made in NVDA.  With all the hype of the recent FANG+2 stocks, it is not surprising for short-sellers to apply the subjective term of overvaluation to tech stocks that have run up nearly 50% over the past year.  There have been rumblings of similarities to the 2000 tech bubble for some time.
With regard to the FANG+2 stocks it has come to pass that without overweighting these favorite LargeCap growth stocks, it is virtually impossible to outperform the S&P 500.  While this is true to some degree, but generalization does not take into account that the 50 largest winners in the S&P 500 were up 8.35% year-to-date through April, while the 50 worst performers were off 6.57% over the same period.  It is also interesting that for year-to-date through last Friday, the Equal Weight S&P 500 rose 8.62%, while the Cap Weight S&P 500 was up 8.25%.  Whether the large tech valuations are ahead of fundamentals is a subjective judgement and not a primary consideration for momentum traders.  Academics believe that
an efficient market for stocks exists however, people like Andrew Left have shown value is in the eyes of the beholder or short-sellers.  Others note that the S&P 500 has not had a 5% selloff since July 2016 - - the longest time period since 1996.   
The immediate response to the Tech selloff among the many professionals was a reorientation of portfolios away from Tech and into Financials.  This is not readily apparent although there is rationale to such a rotation.  Since the beginning of the year through last Friday, the S&P 500 GICS Financial sector was up 4.1%, while Tech rose 18.6%.  The Fed is expected to raise interest rates 25 basis points this week and, the Comprehensive Capital Analysis and Review is being released by the Federal Reserve on June 28 and many expect the report to show the benefits of lessened regulation; giving economic rationale to rotation.  Also, money managers and individuals hold outsized profits in Large-Cap tech stocks (S&P 500 GICS Technology Sector is up 32.0% year-over-year), an incentive to taking long-term capital gains at current levels.
Whatever the reasons for the selloff in the Tech Sector, the companies that have gained 40% or more since the beginning of the year are correcting.  But it will not be long before 2Q2017 S&P earnings are reported.  According to FactSet, current estimates are for a rise of 6.6% for earnings and 4.9% for revenues.  Nine sectors are estimated to show earnings growth, led by Energy (+404.3%), Technology (+9.3%) and Financials (+7.2).  All sectors except Telecom are expected to have revenue increases.   The current Tech selloff should not broaden to other sectors and it is more likely that any rotation will increase purchases in economic sensitive companies rather than out of equities.  The companies experiencing the rapid price depreciation are for the most part, innovative/well-managed and profitable with a growth outlook.  Readjustments of equity prices and sector rotation are common characteristics of bull markets working in conjunction with the business cycle.   
By Tuesday, most of the affected Tech stocks have stabilized and reversed course.  There is no guarantee that the selloff is exhausted.  There is a growing recognition that many of these Large-Cap Tech stocks are long-term winners.  The sharp declines on Friday and Monday morning are characteristic of algorithmic trading.  After three days, NVDA is at $150, down from its closing high on June 8th of $160, a day prior to the Citron report.  

Investment Policy

Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors become frustrated with slow implementation of stimulative policies. However, any correction should be considered a long-term buying opportunity.  It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted.  Realistically the positives from expansionary fiscal policies will take more time than generally expected. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap consumer, financial, industrial and technology companies.  To mitigate the potential of higher-than-expected inflation and multiple compression, portfolios should include value companies exhibiting sustainable earnings growth and dividends.

David Minor
Rebecca Goyette

William Hutchens