Technology

The equity rally has been in a holding pattern, with some tactical fraying around the edges.

A technical breakout in communications equipment relative performance is being fundamentally-driven. New orders for communications equipment have perked up, led by a re-acceleration in telecom services capital spending (second panel). The telecom service sector has enjoyed the strongest revenue growth of all sectors this quarter, and free cash flow is growing at a mid-teens rate (middle panel). That is driving a pickup in investment, a positive omen for equipment demand. In addition, there is pent-up demand for communications gear following more than a decade of underinvestment. Even telecom equipment exports have recovered, signaling an undercurrent of global demand in an otherwise lackluster world economy. This is powering double-digit sales gains. That is translating into solid output growth and rising productivity. The implication is that dirt cheap valuations are primed for a re-rating, and we moved this group onto our high-conviction overweight list in yesterday's Weekly Report. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV.

Despite our reservations about the broad tech sector, which has bounced under the leadership of only a handful of stocks, we are encouraged by the outlook for the communications equipment sub-component. This extremely undervalued group is enjoying a broad-based technical breakout, based on fundamental improvements. Our industry relative advance/decline line has touched new highs at the same time that the share price ratio has broken decisively above its multiyear downward sloping trend-line on an upsurge in momentum. That alone is indicative of a major trend change, a view that is driven by positive macro forces, please see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV.

A two-speed economy requires selective portfolio construction, favoring consumer-oriented and mainly non-cyclical industries. Put communications equipment on the high-conviction overweight list, and stay clear of refiners.

In successful investment analysis "less is more, and usually much more effective."

The breakout in the S&P 500 could boost flows to EM, and momentum could overwhelm fundamentals for several weeks. Nevertheless, U.S. interest rate expectations will rise and it, along with weak EM profits, will cap upside in EM risk assets. Take profits on our short EM stocks/long 30-year U.S. Treasurys position. Reduce short exposure to EM currencies by closing the currency trades where the long side is partially against the yen.

Our <i>Cyclical Indicator Update</i> reveals that a defensive portfolio strategy remains the best bet to navigate the crosscurrents of stagnant profit/economic growth yet abundant global liquidity.

Housing activity should accelerate in the back half of the year given the drop in Treasury yields. Buy home improvement retailers and add to long homebuilding positions.

At current levels, Treasury yields are consistent with our assessment of fair value. Further, the Fed's Labor Market Conditions Index does not suggest an imminent recession. Expect payrolls to stabilize above levels consistent with further progress on wage growth and inflation, allowing the Fed to hike rates later this year.

The S&P technology sector has been drifting lower in relative performance terms, which is notable given that the broad market has made a charge toward the top end of its trading range. The lack of leadership from this traditionally high beta sector reflects ongoing deterioration in earnings drivers. The San Francisco Fed's Tech Pulse Index, a coincident indicator of tech sector activity including employment, output and shipments, has rolled over after a multiyear expansion. Additional downside is probable, given that tech new orders have slipped into the contraction zone on the back of the nascent retrenchment in corporate sector capital spending and relentless contraction in emerging market exports (bottom panel). Technical conditions are warning that the downturn in relative performance is the start of a sustained bear market. Our Technical Indicator has declined into the sell zone after diverging negatively from the share price ratio. Breadth is thin, as far less than half of the sub-industry groups are trading above their 40-week moving average, in relative terms, and/or with a positive 52-week rate of change. The bottom line is that an underweight stance is the best way to protect portfolios from looming underperformance.