Sectors Relative to QQQ

Sector Funds vs S&P 500

The Inflation Trade is Over

This morning's spike in the CPI was the last torching of the inflation bears. Inflation peaked in June 2022 and a lot of bears didn't get the memo. They continued pushing a bearish outlook based on fading inflation, with a resulting series of squeezes. It appears that like the dodo, these animals are now extinct.

All is not well in the markets though, at least this morning isn't yet a clear victory for the bulls. The DJIA reversed all of its CPI gains by 11 AM and Tesla broke to a new 52-week low.

Zooming out, this is supposedly a bear market, but even the technology sector failed to crack its 50-month moving average.

Does this mean it isn't a bear market? Not necessarily. The 2000 bear market was a similarly slow starting affair that was frontloaded with massive losses in speculutive growth stocks. This cycle has crypto, that one had Beanie Babies. It could be a giant correction though, a huge rotation from growth to value, with energy becoming the still-extant bull market's leader. I still lean bearish because the charts strike me as bearish, particularly where many Dow components are situated, yet there is some fog at the current price levels. If the bear resumes, it won't be because of inflation fears. It will be driven by a new fear, most likely recession.

The Bear Pill, Revisited

Back in December 2021, I posted The Bear Pill. In it, I noted:

Here are charts of the utilities and consumer staples SPDRs in 2000, and then compared to technology. Utilities peaked in November and staples in December. Both made their all-time high 8 to 9 months after the dotcom bubble had burst. Between March 24 and December 29, 2000 (simply the slice I grabbed when highlighting the chart), the returns for XLU, XLP and XLK were +32 percent, +41 percent and -51 percent.

Technology Top Isn't Complete

Technology hasn't topped on its own yet and it hasn't topped relative to the S&P 500 Index yet either, but it is close.

Looks Like XLK Already Sold Apple

I made the case for Why You Shouldn't Own Apple Stock. The main reason is its large weight in various indexes. Aside from being an indication of a major market top, it also creates headwinds for funds because they have to sell the position down or not invest inflows into it depending on market conditions. It looks like XLK pulled the trigger early and sold off some Apple. The sale is evidenced by the gap between the weighting of Apple in the fund and in the index. As of September 15 close, both are similar and above 25 percent. A day later, Apple's weight in the fund is down about 1.5 percent. A news item on the SPDR site indicates funds were rebalanced heading into today. They took the opportunity to lighten up Apple exposure.

Apple Can Go No Higher

If XLK goes down, Apple must go down. If XLK goes higher, Apple can go higher, but it must lag XLK otherwise XLK will have to start reducing exposure in Apple by mid-November. Since there are many funds tracking the technology sector or implementing similar strategies, this is a potentially signficant factor should Apple extend its outperformance.

Update: Apple Approaches Regulatory Limits in Technology Sector

I say again, bulls are out of ideas.

Apple is heading for its highest-ever relative close versus XLK. By my math, it is now about 24.8X percent of XLK.

Regulations limit the size of any one holding in a mutual fund or ETF to 25 percent of assets. Funds don't have to make a decision yet because compliance is quarterly. If Apple outperformed moving forward though and held that lead, passive technology funds would become forced sellers by mid-November. This works in both directions. My expectation is this situation will not come to pass because these "impossible" situations have a way of resolving themselves.

Update: I had a put position on for October in Apple back in August that I covered during this rally. I had almost no position since then. As of today, I now have three-times the position I had before with about 4 percent of the position in November puts.

The Bulls are Hiding in Apple

Keystone

A keystone is the wedge-shaped stone piece at the apex of a masonry arch, the generally round one at the apex of a vault. In both cases it is the final piece placed during construction and locks all the stones into position, allowing the arch or vault to bear weight. In both arches and vaults, keystones are often enlarged beyond the structural requirements, and often decorated in some way. Keystones are often placed in the centre of the flat top of openings such as doors and windows, essentially for decorative effect.

The ratio of Apple to XLK hit a new high. As of Friday, August 25, Apple was 24.79 percent of SPDR Technology (XLK). These are moving targets, but if Apple outperforms XLK by about 1.1 percentage points, it will cross the 25-percent regulatory limit. Since the quarter is half over, the fund can allow Apple to rise and stay compliant until the end of September. However, Apple is effectively at its regulatory limit. If it keeps outperforming, it will be force-sold because it cannot remain above a 25-percent weighting.

It's obvious to me that Apple will underperform other technology stocks going forward. The cultish devotion to Apple products may have no limit, but the devotion to Apple stock does. As I explained 10 days ago, there are scenarios where Apple rises such as a broad bull market, but ones where Apple leads the tech sector are extremely outlier events. Impossible scenarios if you ask me. If this is a bear market, there are only two scenarios for Apple.

Scenario One is Apple holds up all the way until the end. Stocks such as Nvidia, Intel, Mastercard and Visa lose (for purposes of illustration, not forecasts) 30 to 50 percent, while Apple is down maybe 25 percent. Managers and investors keep their Apple while dumping everything else tech related first. Passive indexers become forced sellers as Apple weightings in funds surpass regulatory limits. In the final panic phase into the lows, Apple implodes because sellers have to start selling Apple if they want to raise more cash. There will be many "Apple is relatively overvalued" articles. There will be tech stocks selling at 90-percent or higher discounts and Apple only 30 percent off its high. Value guys will make the case for selling Apple and buying beaten down software, semiconductors and so on.

Scenario Two is Apple helps trigger the next bear wave and leads the sell-off. One out of every four dollars redeemed from tech funds such as XLK will be sales of Apple stock. As soon as redemptions exceed inflows, the plug is pulled on Apple and the stock market.

Sector Check-Up

Healthcare (XLV) is the only clearly bullish pattern. Maybe XLU too. Tech sectors (XLY, XLC, XLK) are ugly, but hold potential. Value sectors (XLF, XLRE, XLP, XLI) look like they're rolling over. Materials and energy (XLB, XLE) both rolling over, but they are not required for a bullish move in the broader market. At this point, a rally requires their weakness.

Tech at 3yr Moving Average

Energy and Tech

The ratio of XLE $83 to XLK $138 is 0.60 currently. I predict it will get to at least the 1.5 area by the time this bear market completes (or this phase of it if it lasts for many years).

The ratio has almost doubled this year with XLE rising over 50 percent and XLK down about 20 percent.

Below is a chart with a blue line at the 1.50 ratio along with a table showing various XLK prices for given XLE prices. As a rule of thumb, there is still around 40-percent of the S&P 500 Index in tech and companies that trade like tech stocks despite being in other sectors. XLK has a flat return if XLE gets to around $200 and that ratio, a doubling of XLK requires XLE at $400 or better than a quadruple. 

If one expects structurally higher energy costs moving forward, the outlook for tech is grim and/or the outlook for energy is very bullish. There is no reason to be investing in tech or in the major indexes with their massive tech exposure, unless one doesn't expect inflation/higher energy. A return to the 2009-2020 economy.

Apple and Microsoft Hit Their Natural Limits

Funds may start outpeforming again thanks to BigTech become so large a slice of the market that it runs afoul of SEC diversification rules.

Morningstar: Why Some Fund Managers Have to Bet Against Apple and Microsoft Stock

Diversified managers face a real conundrum when it comes to the index's top two stocks, especially. No matter how bullish they are on Apple and Microsoft, they have almost no wiggle room to overweight them. Instead, it leads many of them to bet against the two by owning proportionately less than the index. In fact, all 55 medalist strategies collectively underweight the two stocks. That could hamper these strategies if Apple and Microsoft continue to outperform the broader index and their managers can't find opportunities among relatively smaller companies to make up for the lost ground. This issue affects most large-growth fund owners; of the $1.8 trillion of mutual fund assets in the large-growth category, $1.4 trillion sits in officially diversified mandates.

It's a well written article that explains everything. If you don't want to read it: the SEC has some quirky diversification rules. The bottom 75 percent of a portfolio cannot hold more than 5 percent in any stock. Apple and Microsoft are 23 percent of growth. THe rest of tech adds up to 50 percent of the Russell 1000 Growth Index. This means there's 2 percent to put somewhere, and then Everything else has to be under 5 percent. Growth is highly concentrated in BigTech though, which requires a decision of which BigTech stocks to underweight. Also, Apple and Microsoft cannot keep outpeforming because assume managers are sticking as close as possible to the index. They have to sell if these two go over 25 percent of a fund such as SPDR Technology (XLK). Only in a scenario where you have some big new investors coming in gobbling up Apple and Microsoft shares (leave aside that these companies also have to take over the global economy) could the demand offset the selling pressure. Once you realize this, it's pretty clear these stocks have to underperform. Then you think to front-run the crowd and away it goes...

And then there's Facebook, solving the problem itself.

Tech Ready to Plummet

Google, AMD and Paypal report tonight.

Market Becames More Reliant on Apple

The stock market has spent the past three months becoming ever more reliant on Apple. As a result of Apple's relative strength, it is now 24.15 percent of SPDR Technology (XLK) and 11.64 percent of the QQQ. Microsoft is 21.91 percent of XLK and 10.09 percent of QQQ. The next largest holding in each fund is Nvidia 3.76 percent and Amazon 6.76 percent.

If Apple plunged to $110 this summer, it would't violate the uptrend in place since 2002. Microsoft could be cut in half and it wouldn't violate an uptrend in place since its IPO in 1986.

Energy Versus Tech

The XLE/XLK ratio is where it was in autumn 2000. That is when the bear market went from mostly tech-centric to a broad decline, with the holdouts such as consumer staples staying elevated until November/December. the finaly breakout for XLE/XLK was in late October 2000.

Energy Up, Tech Down

I'll do a longer round-up in a bit, but wanted to note XLE is hitting resistance areas again in pre-market. There is a conjunction of long-term resistance lines there.

I've talked about the 10-year yield being crucial, and energy is a component of that. There's a monster inverted head-and-shoulders pattern there. If that pattern completes, the target is $100 on XLE. A 67-percent increase from the current price. If that completes, if energy breaks out, all hell is going to break loose in the financial markets. I have weekly puts on XLE that will get stomped if XLE doesn't back off quickly, but I have a lot more in Apple weekly puts I picked up around the same time that are getting greener. As I've been doing for the past year or more, I'm persistently more bearish on technology because I see a no-win scenario. Either the pattern since 2008 holds, with commodities and markets reversing sharply right when it seems like inflation is taking off, or inflation and interest rates actually take off. The latter scenario is worse for technology and related financial assets. If energy breaks out like that chart implies, financials may also collapse like a house of cards because rates will rise too quickly, devaluing their assets faster than they can grow them with new lending. That's more speculative though. What I'm most confidence about is that tech is doomed, which is why most of my money is betting against it.

Imagine Buying Tech with Central Bankers Cheering on Double-Digit Inflation

Then compare to the relative price of financials, energy and materials.

The only question is when, not if, the tech bugs find their windshield.