Ketu Desai
By Ketu Desai
One of the defining features of the rally over the past year is that it has been very narrow. The top seven tech stocks have outperformed the remaining 493 by 70 percent since the start of 2023. The price action is backed up by earnings growth. Over the past year, large cap tech grew sales 15 percent with margins up 6.1 percent leading to 60 percent earnings growth. Compared to the remaining 493, which grew sales only by 3 percent with margins contracting and earnings falling 2 percent.
Large cap tech is expected to grow earnings on average 64.9 percent in 2024 and 26.5 percent in 2025. On a growth adjusted basis (PEG) these names trade at a discount to the rest of the index. While the rest of the market remains highly rate dependent, large cap tech has started to diverge from rates. As the economic data continues to run hot, the market has priced out three cuts for this year and the 10YR is up 37 bps YTD. One of the reasons that large cap tech has diverged from rates and can continue to outperform in a higher for longer rate environment is their massive cash balance which now earns 5 percent.
These companies have nearly $500 billion in cash on their balance sheets, which is 20 percent greater than the entire market cap of Johnson & Johnson. AI is a unique technological shift that benefits those with capital, data, and scale. With higher rates it makes it considerably more difficult for new competitors. Uber, while not a large cap tech company, is a good example of how a considerable barrier to entry is forming for these types of companies. Cheap financing allowed venture capitalists to fund losses at Uber for more than a decade. This allowed Uber to build out a network and customer base. In a higher rate environment, it is unlikely that losses for a new competitor will be funded for that long, further strengthening the competitive position for the current market leaders.
Tech is not the only game in town, there is meaningful upside in many other areas of the market. One that stands out is financials. The sector is expected to have the highest revenue growth outside of the large cap tech names. Earnings have been revised up to 10.9 percent for 2024 from 7.5 percent at the start of the year. They are expected to grow earnings another 11.4 percent in 2025. It is likely that these numbers will get revised upward as capital markets, deal-making, the economy, and the curve normalize.
There has already been $425 billion in M&A so far this year, up 130 percent year-over-year. As the yield curve normalizes, net interest margins will expand. The combination of a housing and capex rebound should drive lending. We are starting to see consolidation in the industry, most recently with Capital One buying Discover. They trade at just 12x cash flow, a 23 percent discount to the S&P. Flows have been negatived out of financials for more than a year. The sector has been hated since the Great Financial Crisis. Technically, the sector is breaking out to new highs from a 20-year base. When a sector with fundamental tailwinds, cheap valuation, low positioning, and a large technical base, breaks out, the gains tend to be very significant.
One of the things that has become increasingly important for investing in public markets is understanding who your fellow investors are. Especially ones that drive incremental moves. The market is now driven by a few important constituents, multi-manager platforms (pod-shops), CTAs/macro funds/quants, and options traders. The commonality among them is that they are mostly trend followers and momentum players. They usually are less sensitive to valuation. This makes it difficult for traditional value investors, who will have to rely more on shareholder return of capital.
The options market has become increasingly more important. Zero-day to expiration options (daily options) now account for nearly 50 percent of flow. They drive daily moves from both investors and dealers. These are non-fundamental flows that are available to be taken advantage of for longer-term investors. Another impact, mostly driven by the sector specialists at pod-shops, is that we see significant differentiation in winners and losers within sectors. Sector specialists usually run low-net exposure with longs and shorts within a sector. They manage north of $350bn in AUM and significantly more on a gross basis. Most of them are looking at similar things, therefore they pile into the same longs and shorts.
The CTAs/macro/quants which rely on technicals exacerbate these moves. This causes significant sector level dispersion. For instance, in energy you can see divergence between refiners and oilfield services; obesity and cancer vs. others in pharma; med-tech vs. insurers in healthcare; Meta/Netflix/Nvidia/Microsoft vs. Apple/Tesla/Alphabet in large cap; Nvidia/Broadcom/AMD vs. other semis; JPM vs. regional banks; defense vs aerospace in industrials; travel vs. retailers in consumer discretionary. In each sector you will find these types of divergences.
Understanding who your fellow investors are and how they invest can provide a meaningful boost to your portfolio.
Looking forward, the market will focus on the Fed meeting, economic data, and the election primaries.
Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. ketu@isquaredwealth.com
