Technology

Semiconductor stocks finished last year on a strong note, supported by a surge in M&A and hopes that low oil prices would spur an increase in consumer spending, particularly on electronics. While the latter has improved, the M&A backdrop is becoming more hostile as the cost and access to capital become more restrictive. We put this group on our high-conviction underweight list to reflect our concern that once M&A euphoria faded, a renewed focus on fundamental profit drivers would trigger a de-rating. Apart from better spending on electronics, the data continues to support our bearish call. Global semi sales are shrinking, with key producing countries like Korea and Taiwan suffering from a steep export contraction. That implies heightened liquidation pressures, which will undermine profit margins. Worse, semiconductor companies have been slow to downsize despite threats to top-line growth, adding to profit margin pressures, please see the next Insight. The ticker symbols for the stocks in this index are: INTC, TXN, AVGO, MU, ADI, SWKS, LLTC, XLNX, NVDA, MCHP, QRVO, FSLR.

The defensive qualities of the S&P data processing index have served investors well in recent years, particularly given its hedge against deflation pressures (top panel). However, the index is now priced for perfection and our Indicators suggest that peak performance is in the rearview mirror. Industry sales are linked to transaction volumes. Real consumer spending growth is slipping, despite rising wage inflation, reflecting an increase in the personal savings rate. Access to credit is deteriorating, on the margin, and consumers demonstrate little appetite to re-lever. The slide in revenue is hitting profit margins, as both capital spending and SG&A expenses are accelerating as a share of turnover. Meanwhile, the ISM services index is starting to play catch up with the decline in the ISM manufacturing index. A closing of this gap has previously warned that investor appetite for the services-based data processing group may diminish, at least for a few months. As a result, we recommend taking profits of 23% and downshifting to neutral. The ticker symbols for the stocks in this index are: ADP, ADS, CSC, FIS, FISV, MA, PAYX, TSS, V, WU, XRX.

U.S. dollar softness may be sparking a subtle shift in sub-surface dynamics, to the benefit of select deep cyclical industries. Switch from rails into electrical equipment, and take profits in data processing.