From Sean Brodrick: You could pave the road to hell with the bodies of analysts who have tried to call a market top this year. So, let me take a swig of courage. Because I strongly believe Highty Mighty Tech stocks are about to be humbled.
And the coming swoon could rattle Wall Street from one end to the other.
This is happening even though there are several signs of strength in other parts of the global economy …
Heck, palladium, copper, aluminum and other industrial metals are hitting multiyear highs. Gold and silver are looking good, too. Oil shows surprising strength, though oil companies remain the market’s doormat.
The reason for the commodity boom is China shifting into higher gear. And this hungry tiger is ready to eat all the raw materials we can shove into its maw.
But that’s a cycle that is ramping up at one end of Wall Street. At the other end, tech is a balloon that is fast leaking hot air.
And boy, has that balloon soared …
Look at that. Tech is up nearly 20% this year, far outperforming some other leading sectors. (If you’re looking for the laggard, it’s energy. That’s down 16.5% this year.)
Part of this is good earnings. Tech saw earnings climb 14.7% in the second quarter, while revenue grew 8.8%. But the party may not last much longer. That’s because tech earnings and net profit margins are projected to fall in the third quarter.
Weak Dollar Worked Wonders
Another explanation for the boom is the falling U.S. dollar.
How much it matters depends on who you talk to. But Morgan Stanley analysts say that for every 1% drop in the dollar, S&P 500 earnings could gain a half percentage point.
This boosted overseas sales, and padded earnings by 14% in the first quarter, according to Goldman Sachs.
Final numbers for second-quarter earnings aren’t in yet, but the dollar fell by another 5.6%.
And no sector gets more of its income from overseas than tech companies … 57%.
Funny thing, though. The dollar bottomed earlier this month and seems to be heading higher. That wind in the sails for tech may be gone.
And bear in mind, the dollar just has to stop falling to drag on earnings growth.
Sure, this is a problem for tech. But it’s also a problem for the S&P 500 in general.
The Kindest (Tax) Cut
There is one more thing that has boosted tech … and the S&P 500. And that’s Wall Street’s anticipation of tax cuts.
Some folks in the Trump administration are working on this. They’re asking for a 15% corporate tax rate. But they might “only” end up getting 22% or 23%.
So ask yourself: How much of a tax cut is already priced into the markets?
At the same time, Wall Street is expecting a deal on repatriating the massive pile of profits that many large U.S. companies have outside the country.
There is $2 trillion or more kept deferred overseas by U.S. corporations. The way to get that money back is to offer a lower tax rate.
One of President Trump’s campaign proposals was to offer a repatriation holiday for U.S. companies to bring back some cash to the U.S. at a tax rate of 10%, vs. the current corporate tax rate of 35%.
But considering the mess in Washington, Trump may not get all he wants on the repatriation front, either.
What companies will be hurt if repatriation doesn’t work out as anticipated?
You guessed it — big tech companies that have huge profits overseas.
For example, Cisco has $70 billion in cash … but just $3 billion of that is in the U.S.
Does that sound like a lot? Microsoft has nearly $110 billion in profits parked overseas. GE, IBM, Baker Hughes and Pfizer all also have huge cash hoards in foreign banks.
All have been pricing in repatriation. All could be in for some level of disappointment.
Sure, I expect some kind of tax deal will go through. But it may be a “sell the news” deal. Ditto for repatriations.
Red Flags All Over the Market
Meanwhile, some traders aren’t waiting to see how the tax cuts work out. They are already selling the market. Starting with small caps. Or as I call the Russell 2000, “Two Thousand Canaries in the Coal Mine.”
See, small-capitalization stocks tend to be the most-sensitive to changes in economic prospects or overall investor sentiment. So, when the Russell 2000 recently fell beneath its 200-day moving average, that’s a big negative.
And it’s not just the small caps. Across the market, headline stocks are holding up the market. Away from the spotlight, plenty of stocks are getting fed into the wood chipper.
We are also seeing an astonishing number of new lows compared to new highs. Wall Street calls it the Hindenburg Omen. It happens when traders are confused and skittish.
All this tells me that we are in an environment ripe for a correction. And the next step down could be a doozy.
Bottom line: I would not be surprised by a swift, sharp correction in tech. And since bots make up so much of the market now, it could waterfall throughout the market.
The good news is that might bring us to a great buying opportunity.
Here are three things to consider right now:
- Raise some cash. Sell your losers in anticipation of buying bargains at better prices.
- Add some protection. There are inverse funds that can cushion any downdraft.
- No sector is more vulnerable than Big Tech. It’s inflated with hot air. The correction could be teeth-rattling.
The deepest market sell-offs often happen in September and October. Be prepared if the worst happens.
The Technology Select Sector SPDR Fund (NYSE:XLK) was unchanged in premarket trading Thursday. Year-to-date, XLK has gained 20.38%, versus a 10.42% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of The Edelson Institute.