Software and Services

Overweight (High-conviction) Despite recent tech stock ills, software stocks continue to defy gravity and remain in a multi-year uptrend, still above the dotcom bubble relative performance highs (top panel). We reiterate our high-conviction overweight status and within tech we continue to prefer the S&P software and S&P tech hardware, storage & peripherals indexes to the early-cyclical tech S&P semis and S&P semi equipment subgroups. While rising M&A premia have been a core driver of software stock performance, industry operating metrics are on fire which supports the elevated industry valuation multiples. Top line growth is accelerating and running at a higher clip than the broad market. The recovery in the software price deflator (middle panel), a proxy for industry pricing power, corroborates this bright demand backdrop. Impressively, labor additions have been muted, implying that margins can expand further and possibly challenge cyclical highs (bottom panel). Overall, feverish software M&A activity, the ongoing capex upcycle, firming industry operating metrics and pristine balance sheets, suggest that software stocks are a must have for equity portfolios; please see Monday's Weekly Report for more details. Bottom Line: The S&P software index remains a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, RHT, ADSK, CA, SNPS, CTXS, ANSS, CDNS, FTNT and SYMC.

Highlights Portfolio Strategy Frenzied software M&A activity, the ongoing capex upcycle, firming industry operating metrics and pristine balance sheets suggest that software stocks are a must have for equity portfolios. Rising interest rates along with the Fed's quantitative tightening, the return of volatility, higher gasoline prices, stretched technicals and a lack of a valuation cushion all suggest that it pays to remain bearish consumer discretionary stocks. Recent Changes We lifted the S&P Industrial Conglomerates index to overweight in a Sector Insight on Wednesday last week.1 Table 1 Feature Chart 1Stocks Are... The S&P 500 found its footing last week, but the volatility comeback assures more violent oscillations before equities resume their upward trajectory. Crash-prone October lived up to its reputation but it is now over, and once the midterm election uncertainty passes this week, investors will refocus their attention on the U.S./China trade war and U.S. economic growth. Trump's moderating approach on the former was welcome news last week, and any further de-escalation signs in the trade tussle will breathe a huge sigh of relief for equities. On the investment front, the 10% SPX drawdown triggered our "buy the dip" strategy on Friday October 26 (please see the "Time To Bargain Hunt" Sector Insight), when we put to work longer-term oriented capital. Our "buy the dip" view remains intact, as we still do not foresee a recession in the coming 9-12 months. On the volatility front, the CBOE SKEW index, a measure of tail risk,2 is sending a positive message as investors are no longer buying tail risk protection as they did in August. Interestingly, as the nominal level of the SPX has been increasing over the decades so has the price of tail risk protection (Chart 1). We view the recent collapse in the CBOE SKEW index as a positive indication that the worst may be behind the equity market. With regard to global flows to U.S. shores, the Treasury International Capital (TIC) System data revealed that global portfolio managers were not chasing U.S. equities this summer as they had been at the beginning of the year. The likely current trough in net foreign portfolio flows into U.S. equities should, at the margin, underpin U.S. stocks (Chart 2). Chart 2... Likely Out Of The Woods... On the U.S. economic front, the latest GDP release revealed that housing is indeed softening. This is the first time since the GFC that residential investment's contribution to real GDP growth turned negative for three consecutive quarters. Tack on decelerating house prices and collapsing lumber prices (Chart 3) and residential real estate confirms the yellow flag from our recently introduced Economic Impulse Indicator.3 Chart 3...But Housing Poses A Risk While house prices are decelerating, corporate pricing power remains upbeat. True, investors focused on anecdotes about input cost inflation this earnings season and all but ignored evidence that companies across different sectors have been able, and will continue, to raise selling prices by more than the rise in wage and commodity costs. Thus, corporate profit margin squeeze fears are overblown; they are likely a risk for the back half of 2019, especially if volume growth suffers a setback. This week we are updating our corporate pricing power gauge. While our overall proxy has ticked down, it is still clocking higher than wage inflation. In fact, our pricing power diffusion index shows excellent breadth (second panel, Chart 4). This firming corporate inflation backdrop suggests that businesses have been successful in passing on rising input costs down the supply chain or to the consumer, and thus suggests that investors are mistakenly fretting about a looming profit margin squeeze. Chart 4No Margin Pressures Yet While labor cost inflation is trending higher, wage growth remains contained near 3% despite a multi-decade low in the unemployment rate. According to our wage growth diffusion index, just over half of the 44 industries we track have to contend with rising wages, a visible fall from earlier in the year (middle panel, Chart 4). In addition, the Atlanta Fed Wage Growth Tracker remains tame and the switcher/stayer index recently nosedived to multi-year lows. The switcher/stayer index provides a reliable leading indication for the trend in overall labor expenses (fourth panel, Chart 4). Put differently, corporate pricing power is rising on a broadening basis while leading indicators of wage inflation suggest an easing in wage pressures in the coming months. As a result, there are rising odds that expanding forward operating margin expectations are likely, extending the two year margin expansion phase (bottom panel, Chart 4). Digging deeper into our corporate pricing power update is revealing. Table 2 summarizes the results. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power 73% of the industries we cover are lifting selling prices, while another ten industries are experiencing only mild price deflation (less than a 0.6% decline). If we include those ten industries then 90% of sectors are maintaining or raising selling prices. One third of the industries are lifting prices at a faster clip than overall inflation. This is lower than our early-July report. Outright deflating sectors increased by four to sixteen since our last update but only six are deflating at 1% or more. On a slightly negative note, fourteen industries are experiencing a downtrend in selling price inflation, twice as many since our most recent report (Table 2). Deep cyclicals/commodity-related industries continue to dominate the top ranks, occupying the top 7 slots (top panel, Chart 5). Despite the ongoing global export softness, intensifying trade tussle with China and 5% year-to-date appreciation in the trade-weighted U.S. dollar, the commodity complex's ability to increase prices is impressive especially given that the base effects from the late-2015/early-2016 manufacturing recession have filtered out. On the flip side, tech industries dominate the bottom ranks of Table 2. Chart 5Cyclicals Have The Upper Hand In sum, accelerating business sector selling prices will continue to underpin top line growth into 2019. As long as wage inflation rises gradually and does not gallop higher and the corporate sector sustains its pricing power, then profit margins and earnings will remain upbeat. This week we update a high-conviction overweight tech subgroup and reiterate our below benchmark allocation to an early cyclical sector. Software Is In High Demand Despite recent tech stock ills, software stocks continue to defy gravity and remain in a multi-year uptrend, still above the dotcom bubble relative performance highs (top panel, Chart 6). We reiterate our high-conviction overweight status and within tech we continue to prefer the S&P software and S&P tech hardware, storage & peripherals indexes to the early-cyclical tech S&P semis and S&P semi equipment subgroups. Chart 6Software Fever It did not take long for the large CA acquisition to get surpassed by RHT. Inter-industry M&A activity is reaching fever pitch and this frenzy is bidding up premia to stratospheric levels (fourth panel, Chart 6). The push to the cloud, SaaS and even AI has boosted the appeal of software stocks and brought them to the forefront of potential takeout candidates. These are secular trends and will likely continue to gain steam irrespective of the different stages in the business cycle. As a result, software stocks should remain core tech holdings in equity portfolios. Chart 7Capex Gains... Beyond the positive M&A angle that we have been exploring for quite some time in our research, software stocks are particularly levered on capital spending. Chart 7 shows that relative capital outlays and the share price ratio are joined at the hip. Software upgrades offer the simplest, quickest and most effective capital deployment especially when productivity gains ground to a halt. Importantly, leading indicators of overall capex remain upbeat and should continue to underpin software profits (Chart 8). Chart 8...Say Stick With Software Moreover, industry operating metrics are on fire. Top line growth is accelerating and running at a higher clip than the broad market. The recovery in the software price deflator (middle panel, Chart 9), a proxy for industry pricing power, corroborates this bright demand backdrop. Impressively, labor additions have been muted, implying that margins can expand further and possibly challenge cyclical highs (bottom panel, Chart 9). Chart 9Operating Metrics Are Firing On All Cylinders With regard to financial statements, software stocks have pristine balance sheets with more cash on hand than debt, which sustains the net debt-to-EBITDA ratio in negative territory. Interest coverage is great at 10x and free cash flow generation is expanding smartly (Chart 10). Chart 10Pristine Balance Sheets Nevertheless, all of these positives have pushed several valuation metrics to a premium to the broad market and leave little space for any mishaps. On a forward P/E, trailing P/S, and even EV/EBITDA basis, software equities are pricey, but we think for good reason (bottom panel, Chart 10). This rerating phase will likely continue until there is evidence of an end either to the M&A frenzy, or capex upcycle or business cycle. In sum, feverish software M&A activity, the ongoing capex upcycle, firming industry operating metrics and pristine balance sheets, suggest that software stocks are a must have for equity portfolios. Bottom Line: The S&P software index remains a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, RHT, ADSK, CA, SNPS, CTXS, ANSS, CDNS, FTNT and SYMC. Consumer Discretionary Stocks Are Still A Sell While we remain constructive on financials that benefit from higher rates, we continue to recommend investors avoid the consumer discretionary sector - the other early cyclical - that suffers when interest rates rise. Chart 11 depicts this inverse correlation consumer discretionary equities have with interest rates, especially the fed funds rate. Most discretionary equites are levered off of floating rates and thus any increase in the fed funds rates gets reflected immediately in banks' prime lending rate. Also, most consumer debt is floating rate debt and thus tighter monetary conditions, at the margin, dampen consumer debt uptake and, as a knock-on effect, weigh on discretionary consumer outlays. Chart 11Rising Fed Funds Rates... Last week we highlighted that, now that the Fed has been raising rates and allowing bonds to roll off its balance sheet, volatility is making a comeback. Unsurprisingly, the consumer discretionary share price ratio is inversely correlated with the VIX index, signaling that more pain lies ahead for this early cyclical index (VIX shown inverted, Chart 12). Chart 12...The Volatility Comeback... Money aggregates also corroborate that the time to buy consumer discretionary equities is when the money supply is galloping higher and shed exposure when both M1 and M2 are decelerating as we have shown in previous research. Importantly, the velocity of M2 money stock is inversely correlated with relative share prices and the current message is negative for consumer discretionary stocks as GDP is finally growing faster than M2 money growth (velocity of M2 money stock shown inverted, Chart 13). Chart 13...And Money Velocity Point To More Losses In Consumer Discretionary Not only are higher interest rates anchoring consumer discretionary stocks but rising energy prices are also dealing a blow to this sector. Chart 14 shows our Consumer Drag Indicator (CDI, comprising mortgage rates and energy prices). Historically, our CDI has been an excellent leading indicator of relative share price momentum. Currently, the message is clear: the sinking CDI signals that a bear market in consumer discretionary stocks has likely commenced. Chart 14Heed The Message From The Consumer Drag Indicator Sentiment and technical indicators also point to more downside ahead for this interest-rate sensitive index. Our sector advance/decline line is waning and EPS breadth has plunged (Chart 15). Worrisomely, sell-side analysts are penciling in an extremely optimistic 5-year outlook with EPS growth north of 30%/annum or twice as high as the overall market. Clearly this is not realistic as it assumes a near quadrupling of EPS in the coming 5 years. Chart 15Bad Breadth... In the near-term, analysts are more cautious (bottom panel, Chart 15). Relative EPS estimates have already given way as AMZN commands very little EPS weight, despite its massive market cap weight (30% of the S&P consumer discretionary sector), and suggests that relative share prices will converge lower (top panel, Chart 16). As a result, the 12-month forward P/E ratio is trading at a 27% premium to the broad market and significantly above the historical mean. Technicals are almost as extended as relative valuations and cyclical momentum has likely peaked, warning that a downdraft in relative share prices looms (Chart 16). Chart 16...With Poor Technicals And No Valuation Cushion Adding it up, a rising interest rate backdrop along with the Fed's quantitative tightening, the return of volatility, higher gasoline prices, stretched technicals and a lack of a valuation cushion, all suggest that it pays to remain bearish consumer discretionary stocks. Bottom Line: The path of least resistance is lower for the S&P consumer discretionary index, stay underweight. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Sector Insight, "A Rout For Conglomerates Opens A Buying Opportunity," dated October 31, 2018, available at uses.bcaresearch.com. 2 "The crash of October 1987 sensitized investors to the potential for stock market crashes and forever changed their view of S&P 500® returns. Investors now realize that S&P 500 tail risk - the risk of outlier returns two or more standard deviations below the mean - is significantly greater than under a lognormal distribution. The Cboe SKEW Index ("SKEW") is an index derived from the price of S&P 500 tail risk. Similar to VIX®, the price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options. SKEW typically ranges from 100 to 150. A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal, and the probability of outlier returns is therefore negligible. As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant. One can estimate these probabilities from the value of SKEW. Since an increase in perceived tail risk increases the relative demand for low strike puts, increases in SKEW also correspond to an overall steepening of the curve of implied volatilities, familiar to option traders as the "skew"." Source: CBOE, http://www.cboe.com/products/vix-index-volatility/volatility-indicators/skew 3 Please see BCA U.S. Equity Strategy Weekly Report, "Icarus Moment?" dated October 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Special Report

Highlights The renaming of telecommunication services and reallocation of some tech and consumer discretionary stocks ends a long run of a purely domestic, defensive GICS1 sector. Our initial recommendation is underweight for the newly minted S&P communication services sector. Interactive media & services, formerly (mostly) internet software & services, is moving from tech to communication services where it promises to be the core revenue and profit driver of the sector. However, regulatory risk, a rapid pace of change with extremely low switching costs and currency exposure in a very international sector keep us on the fence. We are initiating coverage on the S&P interactive media & services index with a neutral recommendation. Feature Several Indexes Have Found New Homes At the market's close last Friday, investors welcomed a new (rather, a renamed) GICS1 sector to the industry taxonomy: the S&P communication services sector (Table 1). The change had long been overdue as the progenitor sector, telecommunication services, had been hollowed down to three companies and represented approximately 2% of the S&P 500. Further, finding homes for various new media and technology companies had left a hodgepodge of consumer discretionary and information technology subsectors that bore little resemblance to their respective peers. In short, we welcome the new taxonomy. Table 1Classification Changes However, this change brings a good deal of uncertainty with it. The most recent GICS1 change was the reallocation of real estate (mostly REITs) from a financials sub-index to their own GICS1 classification; this change involved a relatively simple carve-out. The creation of communication services includes carve-outs as well as stock-by-stock changes for a brand new index with a core sub-index, interactive media & services, that we initiate coverage on later in this report. Importantly, the reshuffling dilutes an up-to-recently pure-play safe haven index. Previously, telecommunications services was an ultra-low beta, high-dividend yielding, zero currency-exposed prototypical defensive index. Communication services will be dominated by relatively high beta, low dividend yielding and heavily international stocks. In more detail, it morphs into a roughly 45% deep cyclical, 37.5% early cyclical and 17.5% defensive index. MSCI has proposed classifying communication services as cyclical, with no new defensive offset, meaning the market has lost a GICS1 defensive sector. Further, we estimate roughly 20% of the communication services index is value-oriented, a fairly drastic change from the 100% value-oriented former telecommunication services index. Now approximately 60% will be growth-oriented and the balance a blend of the two. One would presume that adding many new stocks to the sector would alleviate telecommunication services' lack of breadth (two companies split 95% of the market cap weight roughly evenly). However, the sheer dominance of Alphabet and Facebook, which will combine to represent approximately 40% of the S&P communication services sector, means that the absence of breadth is being replaced with less absence of breadth (Chart 1). Chart 1Before... And After Further impacting the cyclicality of the new index is the source of revenues. Telecommunication services revenues are relatively inelastic as the service they provide is very much a consumer staple. Communication services in general and interactive media & services in particular have much more volatile revenue profiles, relying heavily on ad sales (Facebook & Google) or consumer discretionary spending (Netflix & Disney). We have not covered the index that includes Facebook and Alphabet, so we have been de facto at a benchmark allocation. As detailed in the following section, we are not changing that recommendation with our initiation of coverage. Our telecom services recommendation remains underweight (though obviously now a subsector within communication services). Our recommendations on the other material industries moving into communication services (movies & entertainment and cable & satellite, collectively the media indexes) are similarly remaining unchanged at a benchmark allocation. Bottom Line: The net result is that we are negatively biased on the new S&P communication services sector and our initial recommendation is underweight. For investors seeking tech exposure we continue to recommend the S&P software and S&P tech hardware, storage & peripherals tech sub-indexes that are high-conviction overweights. Please see the housekeeping section at the end of this report for more details. Interactive Media & Services - Breaking Out? The new interactive media & services index broadly matches the former internet software & services index (that used to be a subsector of the information technology GICS1 sector), but with a twist. Facebook & Alphabet comprised more than 90% of the old index and will command a similar share of the new. However, eBay has found a new home alongside Amazon in the consumer discretionary index, swapping places with TripAdvisor. Meanwhile, Akamai and Verisign are moving to a new index, internet services & infrastructure. Still, the vast majority of the index was, and remains, weighted to two companies. Accordingly, and in the absence of new forward looking data, we will be basing much of our analysis on the old internet software & services index and extrapolating it to the new interactive media & services. It comes as no shock to market observers that the internet services & software index has been gaining share of the S&P 500 as its component stocks have been roaring ahead. In fact, the streak of outperformance has been uninterrupted from the beginning of 2017 until very recently (Chart 2). The usual conclusion is that this is the result of a dramatic surge in valuation. While it is true that the internet services & software index trades at a hefty valuation multiple from an absolute perspective, the valuation has in fact declined relative to the broad market since the beginning of 2017 (Chart 3). Underlying the meteoric rise in market share of the internet software & services stocks without a corresponding relative valuation increase has been a step higher in relative earnings. As shown in Chart 4, earnings growth in this index has vaulted higher in the past five years, dramatically outpacing the growth in the share price for most of the past three years. Chart 2Rising Prices Amidst... Chart 3... Falling Valuations Chart 4EPS Growth Has Outpaced Price A key differentiator between this index and virtually every other index we cover is the source of revenues and earnings, namely advertising. Despite years of acquisitions and organic R&D building non-advertising businesses, last year saw 86% of Alphabet's revenues derived from advertising. The number is even larger at Facebook, where nearly all of its revenues are generated through selling advertising placements. This revenue quite obviously comes with a high margin and extremely high operating leverage. As such, the past decade of economic expansion has been excellent for the index. In fact, Facebook's entire history as a public company has been in the midst of a bull market. The elevated degree of cyclicality of internet software & services profits largely explains the earnings outperformance in the expansion to date, though clearly presents a risk to relative profitability when the cycle turns. Profit Growth Has A Long Runway... Consumer confidence, which is still pushing up against multi-decade highs, combined with online's growing share of advertising dollars, will continue to drive revenue growth of interactive media & services well ahead of the broad market. Such historically high consumer confidence is supported by generationally low unemployment (Charts 5 and 6). In other words, as long as everyone who wants a job has a job, interactive media & services revenues are relatively secure. Chart 5Ad Revenues Are Solid... Chart 6... When Jobs Are Plenty A rebuttal to that bullish thesis that has grown more common since Facebook issued downbeat guidance in July that subsequently knocked more than $130 billion of market cap off the stock (it has since fallen even further) is that growth is decelerating and margins are tightening considerably. Google too has been downplaying cresting EPS growth rates. We counter with the argument we postulated in our mid-summer analysis of the impact of regulatory reform on the technology sector that negativity coming from management at these firms may be sandbagging to defray some of the elevated regulatory scrutiny into their outrageous profitability.1 Further, the sell side does not appear to believe the guidance; current estimates for revenue growth at Facebook & Google for the next three years are a 20% and 17% compounded annual growth rate (CAGR), respectively, or three times as high as the broad market. Nevertheless, even the always-optimistic sell side is calling for EPS growth rates that trail revenue growth, implying the message of declining profitability is hitting home; Facebook and Google have three-year EPS CAGRs of 16% and 12%, respectively. Under the watchful eye of regulators across the world, both firms are investing heavily in safety & security that each has flagged as a significant headwind to margins. While these growth rates are a far cry from earlier profitability, they broadly match the current S&P 500 long-term EPS growth rate of 16%. ...But Three Key Risks Keep Us On The Fence The declining profitability of the sector brings us to the first of three key risks that prevent us from turning positive on interactive media & services: regulation. In the previously noted analysis of regulatory reform on the tech sector,2 our colleagues in BCA's Geopolitical Strategy service noted that both concentration and privacy concerns should present significant sources of apprehension for investors. We would certainly agree. The stock market reaction to regulation (or regulatory action in the form of fines) has thus far been muted, but that does not put us completely at ease. We are conscious that an antitrust breakup of Google or a privacy/data sharing/first amendment issue action against Facebook or Twitter could be potentially business model-breaking. Accordingly, we weigh this against the index's spectacular profitability. With respect to our second key risk, we are reminded of a quote from Donald Rumsfeld in 2002: "there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns -- the ones we don't know we don't know". At BCA, we are neither technologists nor trend experts. Accordingly, there is a great deal of potential changes in consumer tastes or technology that we are unaware of that could deliver the same fate to Facebook and/or Google as the fallen tech giants of the past. In an environment where switching costs appear to be close to nil, this is particularly risky. This could come about either from within Silicon Valley where Schumpeter's creative destruction process is alive and well (keep in mind Google did not exist prior to 1998 and Facebook was born in 2004), or even from China that apparently has jumped ahead of the U.S. in terms of AI capabilities. Some early signs are worrying. A survey from the Pew Research Center last month said that 26% of respondents had deleted the Facebook app from their phone in the past year.3 While the core Facebook application is just one of several of the company's properties, recent news that the founders of Instagram, Facebook's second largest social media network, were exiting amidst internal turmoil reinforces our fears. We are unable to put our finger on how social media tastes or the technology used to consume content will change, but we are confident that any change will be both rapid and unpredictable. Chart 7U.S. Dollar Risk Our third risk is also the biggest: the U.S. dollar. One of BCA's key views for the next year is the appreciation of the U.S. dollar; we have been flagging this as the key source of risk to our otherwise sanguine view on the broad U.S. equity market in general and the heavily international tech sector (the early-cyclical semi and semi equipment sectors are the most exposed and we are underweight both4) in particular. Overseas sales for Facebook and Google represented 51% and 53% of overall sales, respectively, in 2017 and both companies have indicated growth outside North America will outpace domestic sales. Google's recent rumored foray into China is not only encouraging more government scrutiny of the search giant, but it would also exacerbate the EPS sensitivity to forex fluctuations. As long as the U.S. dollar is appreciating, the translation of foreign sales and profits to the home currency will further dampen EPS growth (Chart 7). In the context of the elevated valuations these companies share, combined with the empirical reactions when earnings or guidance have disappointed in the past, any headwinds to growth may drive a valuation derating. Bottom Line: Innovation and supportive macro trends are likely to keep driving profit growth in interactive media & services that, though slower than in the past, still outpaces the broad market. However, three key risks keep us on the sidelines: a renewed regulatory focus, rapid unpredictable changes in tastes & technology and an appreciating U.S. dollar that threatens to sap growth in the key foreign segments. We are initiating coverage with a neutral rating. The tickers in this index are BLBG: S5INMS - GOOG, GOOGL, FB, TWTR, TRIP. Housekeeping Items With the exception of the new neutral recommendation on interactive media & services, we are not changing any recommendations on any other sector with this report. However, in accordance with the GICS changes, we are shifting a number of sectors today. First, we are renaming telecommunication services to communication services; telecom services remains an underweight subsector under the new banner. We are moving four indexes from consumer discretionary to communication services: advertising (overweight), cable & satellite (neutral), movies & entertainment (neutral) and publishing (neutral). Though the new sector has one overweight subsector (advertising) and one underweight subsector (telecom services), the much greater weight of the latter subsector biases our recommendation on the communication services sector to underweight. Within consumer discretionary, our recommendation prior to this change was underweight. As we are moving only neutral- and overweight-recommended subsectors out of the larger index, our underweight recommendation for consumer discretionary is unchanged (modestly more negative, especially if we consider our recent intra-housing market sub sector swap5). Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018, available at uses.bcaresearch.com. 2 Ibid. 3 Pew Research Center http://www.pewresearch.org/fact-tank/2018/09/05/americans-are-changing-their-relationship-with-facebook/ 4 Please see BCA U.S. Equity Strategy Weekly Report, "Party Like It's 2004!" dated September 17, 2018, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Indurated," dated September 24, 2018, available at uses.bcaresearch.com. Current Recommendations

As the SPX and a slew of other indices have vaulted to fresh all-time highs, a deeper dive into profit margins is in order. While the S&P 500's profit margins are benefiting from the one-time fillip of lower corporate taxes in calendar 2018, it is important to remember that this is not affected by any massaging from CEOs/CFOs of the share count. In other words, given that "per share" cancel out of EPS/SPS, this margin number represents organic profit and revenue growth. The chart shows that SPX margins have recently slingshot to all-time highs. However, excluding tech they remain below the previous cycle's peak hit in mid-2007. While we are not fans of excluding sectors from our analysis, the magnitude and persistence of the tech sector's profit margin expansion is surprising. Tech sector profit margins are twice the SPX's margins, and tech stocks have been pulling SPX margins higher consistently for the past 8 years. The implication is that SPX EPS growth of 10% is likely in 2019, but the tech sector has to continue doing all the heavy lifting given the high profit and market cap weight in the SPX. Bottom Line: We remain neutral the broad tech sector and prefer the S&P software and S&P tech hardware, storage & peripherals indexes (both are high-conviction overweights) to the early cyclical tech indexes, S&P semis and S&P semi equipment subgroups (both are underweight). For additional details, please look forward to reading in this coming Tuesday's Weekly Report.

Special Report

Highlights The regulatory or "stroke of pen" risk is rising on FAANG stocks - Facebook, Apple, Amazon, Netflix, and Google; The U.S. anti-trust regulatory framework was designed to curb anti-competitive actions but has evolved to focus mostly on consumer welfare and prices; A shift toward the original regulatory regime would threaten the FAANGs, particularly Google and Amazon; A trade war hit to tech earnings could be the catalyst for a more general selloff today - but this is not our base case; For now, the market will view regulatory risk as noise and tech stocks will likely enter a blow-off phase; We remain neutral, preferring S&P software and hardware while underweighting semiconductors. Feature "I don't know what Twitter is up to." Rep. Devin Nunes (R-California), Chairman of the House Intelligence Committee, July 29, 2018 "I have stated my concerns with Amazon long before the Election. Unlike others, they pay little or no taxes to state & local governments, use our Postal System as their Delivery Boy (causing tremendous loss to the U.S.), and are putting many thousands of retailers out of business." President Donald J. Trump, March 29, 2018 "If we will not endure a king as a political power, we should not endure a king over the production, transportation, and sale of any of the necessities of life. If we would not submit to an emperor, we should not submit to an autocrat of trade, with power to prevent competition and to fix the price of any commodity." Senator John Sherman, 1890 Social media companies have had a terrible week, with Twitter falling 21% on July 27th and Facebook 19% on July 26th. Facebook posted weaker than expected earnings, but investors appeared to be particularly concerned with a miss in monthly active users. The shortfall in active users may have been affected by the new EU privacy rules, which came into force in May. Twitter's fall from grace came even though its revenues were up 24% on the year, with a record profit of $100 million. However, its effort to delete "bots" and suspicious user accounts brought its user total down to 335 million, from 336 million, prompting fears that the platform was slowing down. Twitter's and Facebook's enormous price volatility, despite decent earnings figures, reveals that investors are jittery about the performance of technology stocks, epitomized by the so-called FAANGs - Facebook, Apple, Amazon, Netflix, and Google. They are right to be, given that there are three broad risks to these companies: The next big thing: Before Facebook, there was MySpace. It is not inconceivable that new platforms - for instance, ones that emphasize privacy or that redistribute a portion of advertising revenue with users - could replace current market leaders. Revenue model: Although they are perceived to be cutting-edge technology companies, social media firms generate vast amount of their revenue through advertising. Facebook and Google have captured 25% of global media advertising revenues.1 At some point, Internet companies will reach a ceiling on this revenue as the attrition rate of local newspapers slows, as foreign markets introduce local alternatives (RenRen or Weibo in China, VKontakte in Russia), and as non-tariff barriers to trade begin impacting their international expansion (China's Internet Security Law). Regulation: Finally, regulatory pressure could grow for a number of reasons. First, European concerns regarding user privacy could migrate to the U.S. where a majority of voters already believe that tech companies need greater oversight (Chart 1). In fact, Americans now see tech companies as having as pernicious an influence as energy companies (Chart 2). Second, the U.S. approach to anti-trust problems could evolve away from the current paradigm that focuses on delivering lower prices to consumers. Third, President Trump and his conservative allies could target social media companies with perceived liberal bias for purely political reasons. Chart 1Majority Of Americans Want Tech Regulated Chart 2Tech And Energy Companies Now In Same Boat We have no particular insight into the competitive landscape of social media, web browsing, and Internet retail industries, so we will leave the first two threats to the experts in the field. Instead, we will focus in this report on the third threat, the "stroke of pen" regulatory risk. From Standard Oil To The Chicago School - America's Anti-Trust Framework Today's anti-trust regulatory framework has significantly deviated from the original intent behind the 1890 Sherman Act. As Lina M. Khan argues in "Amazon's Antitrust Paradox," "Congress enacted antitrust laws to rein in the power of industrial trusts, the large business organizations that had emerged in the late nineteenth century. Responding to a fear of concentrated power, antitrust sought to distribute it."2 Railroad construction in the late nineteenth century, largely financed by the municipal debt of farm-belt states, evolved from a shrewd capex investment in a new technology to a mania. To boost sagging profits, railroad barons fixed their prices to reduce competition. State anti-trust laws that emerged out of this era, the so-called "Granger laws," sought to curb monopolistic behavior by giving states control over railroad operations. These state laws ultimately coalesced into federal legislation, the 1890 Sherman Act. No trust had a larger impact on the U.S. legal and regulatory infrastructure than the case of Standard Oil in the early twentieth century.3 Although the company faced criticism in the immediate aftermath of the 1880s recession - particularly from the famous muckraking journalist Henry Demarest Lloyd - the dam broke for Standard Oil when the oil-price bubble popped in Kansas in 1904. A Standard Oil subsidiary - the Prairie Oil and Gas Company - decided to purchase oil by a specific gravity test, forcing some of the Kansas oil from the market. At the time, the oil boom in Kansas had turned many into stockholders in some prospecting company. When oil prices fell, so did the fortunes of these locals. The shock of the price collapse radicalized Kansas politics at the turn of the twentieth century. An idea for a state-owned oil refinery picked up steam in the state despite being labeled socialist. Ultimately, Kansas' delegation in the U.S. House of Representatives requested that the Secretary of Commerce investigate the causes of the low price of crude oil in the state. After several disastrous performances of Standard Oil executives on witness stands and in testimony, the federal government filed a petition against the company in November 1906. A large fine followed in August 1907. The 1890 Sherman Act and subsequent anti-trust policies were grounded in the theory of economic structuralism. "This view holds that a market dominated by a very small number of large companies is likely to be less competitive than a market populated with many small- and medium-sized companies." Through the 1960s, courts blocked mergers - both horizontal and vertical - and policed markets not only for size, or effect on consumer welfare, but also for conflicts of interest.4 In the 1970s and 1980s, however, the Chicago School approach gained prominence. The Chicago School rested on "faith in the efficiency of markets, propelled by profit-maximizing actors."5 While economic structuralists believed that the structure of an industry leads to market outcomes, Chicago School saw structure as the outcome of market dynamics, which themselves are sacrosanct. Chicago School adherents focused primarily on price dynamics and consumer welfare, ignoring how economic structures could create barriers to entry and thus uncompetitive markets. The most influential economist behind the Chicago School was Robert Bork, who asserted in his highly influential The Antitrust Paradox that the "only legitimate goal of antitrust is the maximization of consumer welfare."6 That said, his definition of consumer welfare was incredibly broad and revealed a clear corporate, if not a pro-monopoly, bias.7 The influential Chicago School ultimately impacted the Supreme Court, which declared in 1979 that "Congress designed the Sherman Act as a 'consumer welfare prescription.'"8 The Reagan Administration subsequently rewrote the 1968 merger guidelines to shift the focus purely to consumer welfare in the form of preventing monopolistic price increases and output restrictions. The government also stopped bringing anti-trust cases under the 1936 Robinson-Patman Act, which prohibits price discrimination by retailers among producers and vice versa. Bottom Line: The U.S. anti-trust regulatory framework was designed to curb broad anti-competitive actions of trusts. As Lina Khan discusses in her seminal article, these actions "include not only cost but also product quality, variety, and innovation."9 However, through subsequent regulatory evolution, the Chicago School has taken hold of the U.S. anti-trust process, solely focusing on consumer welfare and prices. We can draw two immediate conclusions from this historical overview of U.S. anti-trust policy. First, the laws on the books have not changed since World War Two. Despite the laws remaining the same, the theory of how to apply them in courts of law has dramatically changed, as economic structuralism gave way to the Chicago School's focus on prices and consumer welfare. If President Reagan and the courts could change how these laws are administered in the 1980s, then so can subsequent administrations and courts in the future. Second, a long period of slow growth, income inequality, and economic volatility - such as the 1870s-80s - can produce a political impetus for anti-trust policy. This was certainly the case for Standard Oil in 1911, which became a nation-wide boogeyman despite most of its transgressions occurring in the farm belt states. While the U.S. has not experienced a recession in almost a decade, it will eventually - and besides, income inequality is a prominent theme once again and a potential source of consumer discontent.10 A narrative could emerge - particularly if politically expedient - that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. Will FAANGs Be De-FAANGed? At BCA Research, we are neither regulatory nor policy experts. As such, we do not have insight into current regulatory activity involving social media companies, Google, or Amazon. The preceding section merely illustrates that the federal government's approach to the anti-trust process could change. Indeed, the Obama administration signaled that its approach could become more active. One quantitative approach that investors can use to assess the risk of anti-trust legislation is the Herfindahl-Hirschman Index (HHI). It is the most commonly accepted measure of market concentration, used by the Department of Justice in assessing whether a particular market is controlled by a single firm.11 Chart 3 shows our reconstruction of the HHI for the present-day era, with three examples from the past. Chart 3Market Concentration By Industry And Eras The 1911 refined petroleum sector harkens back to the aforementioned Standard Oil case; The 2001 Internet browser market refers to the United States v. Microsoft Corp that led to the June 2000 decision (later reversed on appeal) to break-up the software giant; The 1983 telecommunication sector illustrates the HHI for the telecom market at the time of the AT&T divestiture. The data is clear: of the five FAANG companies, only Google reaches a concerning level on the HHI measure. This has already made it a target of European authorities. On the other hand, competition within both streaming (Netflix, Amazon) and social networks (Facebook) appears relatively healthy. However, social networks could be at risk of European-style privacy protections. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes considerable compliance burdens on any company handling user data. California has already signed its own version of the law - the Consumer Privacy Act - which will go into effect in January 2020. These laws give consumers the right to know what information companies are collecting about them and what companies that data is being shared with. They also allow consumers to ask technology companies to delete their data or not to sell it. While tech companies are likely to fight the new California law, we believe the writing is on the wall. The EU is by some measures the largest consumer market on the planet. California is certainly the largest U.S. market. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. Given that advertising revenue is crucial to the business model of social media companies and Google, a significant uptick in privacy regulation could hurt their bottom line. On the other hand, as we discuss below, the new regulatory rules create massive barriers to entry for small firms looking to replace the tech giants. Furthermore, many of the targeted social media companies have run afoul of President Trump in particular and the broader conservative movement in general. As such, privacy advocates - who tend to lean left - and conservatives, who feel that their commentators are being silenced by Silicon Valley, could form a classic "bootleggers and abolitionists" coalition against the FAANGs (Chart 4). Finally, there is the question of Amazon. We do not construct an HHI for Amazon's place in the retail market because E-commerce only accounts for about 9.5% of total U.S. retail sales (Chart 5). Amazon has been leading the charge, but it still accounts for just under half of that 9.5% total figure (Chart 6). Chart 4Conservatives Distrust Tech Companies Chart 5E-Commerce: Steady Increase In Market Share Chart 6Amazon Dominates Amazon's strength is that, in the current anti-trust framework, it conforms fully to the "consumer welfare" priorities elucidated by the Chicago School. Amazon, by and large, lowers prices for consumers. However, several of its practices could be seen as predatory in the more expansive, economic structuralist, approach.12 In addition, President Trump has reserved most of his Twitter scorn on the firm, particularly because CEO Jeff Bezos owns the liberal-leaning Washington Post. Bottom Line: Investors are correct to fret that the "stroke of pen" risk is rising when it comes to FAANG companies. Google scores considerably higher than either Standard Oil or Microsoft on the Department of Justice HHI. Social media companies are already under the microscope by conservative legislators and voters, who perceive them to be biased. Liberals, on the other hand, support toughened-up privacy rules that could undermine the business model of social media companies. Amazon's market dominance is overstated. However, several of its business practices could come under greater scrutiny if any administration should revert back to the original reading of the 1890 Sherman Law. Technology Stocks Have Brought The S&P 500 Up; Could They Bring It Down? It is now a well-worn understanding that the reason why the S&P 500 has performed well is largely due to the performance of a few (enormous) technology stocks (see Chart 7 and Table 1) who have seen both earnings and valuation multiples expand amid one of the longest economic growth phases in history. The preceding section certainly suggests that frothy valuations and the rising regulatory impetus imply that future upside potential is swamped by downside risk. Chart 7FAANG Stocks + Microsoft Have##br## Dramatically Outperformed... Table 1...Generating 50% Of The##br## 2018 S&P 500 Return! If this negative scenario is what actually plays out in the market, the implications could be more severe than in the past. Indexed fund inflows have replaced actively managed fund outflows, as our colleagues in BCA's Global ETF Strategy recently pointed out (Chart 8).13 Considering the rise of these few technology stocks and their increasing weight in the S&P 500 and, necessarily, in the majority of ETFs, more people than ever before are invested in technology stocks, whether they know it or not. Accordingly, the performance of these stocks has become material to the household balance sheet, which is a driver of consumption and, hence, the economy. Thus, it may not be hyperbole to say the economy depends to some extent on Amazon maintaining a high valuation multiple. Chart 8ETF Inflows Offset Actively Managed Outflows Adding some weight to this thesis is the mounting concern over a global trade war. The technology sector in general is by far the most international (as defined by foreign-sourced revenues) of GICS 1 sectors. More specifically, the top three semiconductor & semiconductor equipment companies (INTC, NVDA & TXN), which collectively represent more than 50% of the weight of that index, generate on average only 17% of their revenues in the U.S. Moreover, the more dangerous and lasting trade risk emanates from the U.S.-China showdown, which centers on the technology sector. Should the worst trade outcomes occur, it is not unreasonable to see impaired technology earnings being the catalyst for a more general sell-off. We recommend underweight positions in both the S&P semiconductors and S&P semiconductor equipment indexes. We Think Not Despite the foregoing, we think a more likely scenario is actually a blow-off phase where technology stocks accelerate rather than decline in an increasingly restrictive regulatory environment. In a recent report analyzing sector performance in the last stages of the bull market, we noted that across seven iterations dating back to the 1960's, the information technology sector delivered a median 14% outperformance relative to the S&P 500 (Table 2).14 And, while returns in these stocks have been excellent this year, their gains seem modest compared to the performance in the 1999-2000 iteration. Table 2Tech Stocks Are Strong Late Cycle Performers Underpinning our expectations is the recent stock reactions to regulatory actions. Beginning with Facebook, in the week of March 26, 2018, the firm was hit with severely negative headlines. First, the Cambridge Analytica scandal pointed out that the firm may be caught on the wrong side of EU GDPR rules, followed by the firm being investigated for an EU antitrust suit for the online ad market; the stock fell 15% from the week prior. However, within two months, the stock had fully recovered and a further two months later the stock was up 18% from its starting point. Recently the stock has fallen significantly on the back of very weak guidance; the company noted that revenue growth would decelerate and operating margins would fall to the mid-30% range from the current mid-40% range. It is not unreasonable to think management may be sandbagging earnings growth to defray some of the elevated regulatory scrutiny into its outrageous profitability. Google too has seen negative regulatory headlines, having been hit with a $5 billion fine in the EU for abusing the dominance of the Android mobile operating system in July this year. The stock responded by closing higher and then rose a further 10% in the following two weeks. Overall, we think the market views regulatory risk as noise. For now. But What About The Earnings? Do They Matter? While the earnings implications of yet-to-be-proposed regulatory changes are unknowable, we believe even the pursuit of an answer is a red herring. As shown by Chart 9, the market does not appear to care about next year's earnings as valuation multiples have little consistency with either themselves or the broad market. The implication is that near-term earnings are of relatively little importance, at least compared to the long-term growth outlook. Chart 9Tech Valuations Are Meaningless Further, these companies are a collection of businesses that are not necessarily cohesive. For example, Facebook includes Instagram, WhatsApp and Oculus while Amazon Web Service is a non-retail business that delivers half of Amazon's profit. A reasonable case could be made that breaking up these companies into their components could actually unlock considerable value. Lastly, new regulation, particularly with respect to privacy and data protection, is likely to create significant barriers for new entrants as compliance costs will be relatively more onerous for those companies with fewer resources. Thus, incoming privacy legislation may neuter the impact of any anti-trust legislation. Be Wary With Technology But For The Right Reasons We fully expect more regulation to remain a significant part of the conversation with respect to FAANG stocks and further expect that conversation to promote higher than normal volatility in the sector. However, we also expect the market to mostly look through this risk; buying the dip has thus far been the right approach to headline risk in technology. We think there are better reasons to remain cautious with technology. As noted above, they are heavily international and a strengthening U.S. dollar will be a headwind to 2019 earnings to a greater extent than to the broad market (please see our June 4th Weekly Report for more details). Supporting the dollar, BCA expects higher interest rates in 2018 on the back of rising inflation. Overall, we prefer old tech (S&P software and S&P technology hardware, storage & peripherals, both which are high-conviction overweights) that is levered to our synchronized global capex upcycle theme. It also boasts high cash flow and low valuations. We are less sanguine about technology early cyclicals (S&P semiconductors and S&P semiconductor equipment) which we rate as underweight. Net, we think risks are balanced in the tech sector and maintain a neutral recommendation for the S&P information technology sector. BCA Geopolitical Strategy Housekeeping In light of several announcements regarding China's efforts to ease up on economic policy, we are closing several of our trades: Short China-exposed S&P 500 Companies versus U.S. financials and telecoms - opened on May 30 for a 7.13% gain; Long DXY - opened on January 31 for a 5.85% gain; Short GBP/USD - opened on February 14 for a 6.21% gain; Long Indian equities / short Brazilian equities - opened on March 6 for a 27.54% gain. Long French industrial equities / short German industrial equities - opened on May 16 for a 2.21% gain. We still believe that Chinese structural reforms will continue, weighing on domestic and global growth. In the face of ongoing U.S. fiscal stimulus, the interplay between the two major economies will therefore continue to produce a dollar-bullish environment. However, the dollar's stretched positioning and the Chinese reflation narrative could hurt the greenback while reflating global risk assets in the near term. We will therefore look for an opportunity to reassert our negative EM view. Over the next two weeks, our reports will focus on Chinese stimulus and ongoing structural reforms. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see WARC, "Mobile is the world's second-largest ad medium," dated November 30, 2017, available at warc.com. 2 Please see Lina M. Khan, "Amazon's Antitrust Paradox," The Yale Law Journal 126:710 (2017). 3 Please see Steven L. Piott, The Anti-Monopoly Persuasion (Westport, Connecticut: Greenwood Press, 1985). 4 Khan 718. 5 Khan 719. 6 Please see Robert H. Bork, The Antitrust Paradox: A Policy at War with Itself (New York: Free Press, 1978). 7 By Bork's broad definition of "consumer welfare," even Jeff Bezos is a consumer whose rights have to be protected by anti-trust policy. "Those who continue to buy after a monopoly is formed pay more for the same output, and that shifts income from them to the monopoly and its owners, who are also consumers. This is not dead-weight loss due to restriction of output but merely a shift in income between two classes of consumers. The consumer welfare model, which views consumers as a collectivity, does not take this income effect into account," Bork, 32, our emphasis. 8 Please see Reiter v. Sonotone Corp., 442 U.S. 330, 342 (1979). 9 Khan 737. 10 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 11 Please see The U.S. Department of Justice, "Herfindahl-Hirschman Index," available at justice.gov. 12 Please see Olivia LaVecchia and Stacy Mitchell, "Amazon's Stranglehold: How the Company's Tightening Grip Is Stifling Competition, Eroding Jobs, and Threatening Communities," Institute for Local Self-Reliance, dated November 2016, available at ilsr.org. 13 Please see BCA Global ETF Strategy Special Report, "Do ETF Flows Lead Currencies?" dated April 18, 2018, available at etf.bcaresearch.com. 14 Please see BCA U.S. Equity Strategy Special Report, "Portfolio Positioning For A Late Cycle Surge," dated May 22, 2018, available at uses.bcaresearch.com.

Overweight (High Conviction) The S&P software index has continued to soar this year, helping the NASDAQ set an all-time high this week. Capex surveys are bouncing around the highest levels this millennium; such optimism has typically led software investment and, hence, earnings growth (second and third panels). The market has fully adopted an ebullient stance on U.S. software with the result that our high-conviction overweight trade has gained 15% versus the SPX since the late-November inception.1 At least part of the ascent of the S&P software index has been due to M&A premia being built into stock prices, with CA already being the subject of a takeover bid from AVGO. With the amount of industry consolidation, a speculative lift is hardly a surprise (bottom panel). Still, we view this as the flightiest sort of valuation upside and, from a portfolio management perspective, this morning we suggest that clients institute a stop in this high-conviction call at the 10% relative return mark, in line with our late-January introduced risk management policy. Bottom Line: We reiterate our high-conviction overweight status in the S&P software index, but recommend a 10% stop. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, RHT, ADSK, CTXS, ANSS, SNPS, SYMC, TTWO, CDNS, CA. 1 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com.

Overweight (High Conviction) The S&P software index is on the cusp of breaching the 2000 relative performance all-time peak, and we reiterate the high-conviction overweight status of this key tech sub-index, that is up over 11% versus the SPX since the late-November inception.1 BCA's synchronized global capex upcycle theme is the fundamental driver of our sanguine software industry view. Currently, software investment is outpacing overall capital outlays (second panel). These software capex market share gains on the back of a growing overall capex pie bode well for relative profit growth. Our S&P software EPS growth model corroborates this encouraging news (third panel), pointing to ongoing exceptionally strong earnings growth. Meanwhile, the S&P software index has a pristine balance sheet with virtually no net debt (bottom panel); if our virtuous capex upcycle thesis further bolsters software sales/profits in the coming months, then more gains are in store for the S&P software index that will likely grow into its pricey valuations. Bottom Line: We reiterate our high-conviction overweight status in the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, RHT, ADSK, CTXS, ANSS, SNPS, SYMC, TTWO, CDNS, CA. 1 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com.

Highlights Portfolio Strategy A virtuous software capex upcycle will continue to bolster industry sales/profits in the coming months. We reiterate our high-conviction overweight recommendation on the S&P software index. Depressed relative valuations signal that the weak airline profit margin backdrop is baked in the cake. Rising load factors and the possibility of an easing in jet fuel prices compel us to put this transportation sub-index on our upgrade watch list. Recent Changes Put the S&P Airlines Index on upgrade alert. Table 1 Feature Stocks took it on the chin early last week as geopolitical risks resurfaced in a big way, but managed to bounce smartly and end the week on a high note. Not only did Trump slap new tariffs reigniting trade war fears, but Italian political instability rocked global bond and stock markets. While this mini 'risk-off' phase has rattled investors, the key question hanging over markets is: will the current global growth soft patch prove transitory or morph into a severe global growth deceleration? We side with the former. While it is too early to call the end of the global growth lull, there are high odds that the U.S. will lift the world out of its year-to-date mini-slump in the back half of the year. The third panel of Chart 1 shows that the IHS Markit U.S. manufacturing PMI has been steeply diverging from the J.P. Morgan-calculated global manufacturing PMI. The latter has ticked up recently, and given recent U.S. economic greenshoots and America's heavy weighting in global output, it should pull global growth higher. Chart 1Too Soon To Bail Chart 2Monitor The Greenback's Impact On Profits Importantly, this leading U.S. economic growth indicator is also signaling that SPX momentum will resume its ascent in the coming months, a message corroborated by the latest ISM manufacturing survey print (second panel, Chart 1). What could push our still constructive cyclical 9-12 month equity view offside is a surge in the U.S. dollar. The greenback's trough coincided with last year's peak in global growth (bottom panel Chart 1), and further dollar appreciation - resulting from either stress in emerging markets or a further flare-up of Eurozone breakup risk - would necessitate downward revisions to calendar 2019 sell-side earnings forecasts (Chart 2). We are closely monitoring Eurozone geopolitical risks, and are also awaiting the ECB's response. If persistent turmoil causes the ECB to stay easier for longer than the market expects, then the euro will come under downward pressure against the dollar, especially if the Fed continues to hike as we expect. Last week alone BCA's months-to-hike gauge for the ECB jumped by five months, implying the first hike moved to mid-year 2020 (second panel, Chart 3). We recently showed the U.S. tech sector's hefty foreign sales exposure of roughly 60% of total revenues, greater than for any other GICS1 sector by a wide margin (please refer to Chart 8 from the April 9, 2018 Weekly Report titled "Buying Opportunity?"). As such the technology sector's profits serve as a great leading indicator of any U.S. dollar appreciation related blues. Up to now, tech net EPS revisions have not been sniffing out any currency related earnings trouble that could infiltrate overall SPX EPS (U.S. trade-weighted dollar shown inverted, third panel, Chart 4). Similarly, relative tech sector stock momentum and our tech sector EPS growth model are not waving any yellow flags (Chart 4). Chart 3Steadfast ##br##SPX Chart 4Tech Stocks Will Be The First To Sniff ##br##Out U.S. Dollar Profit Woes Netting it all out, there are high odds that the U.S. will lead global growth higher in the coming quarters and result in a recoupling higher of global growth, assuming the greenback stops appreciating. This would support low double digit calendar 2019 SPX profit growth. Under such a macro backdrop, it still pays to maintain a cyclicals over defensives portfolio bent. This week we are revisiting one tech sector high-conviction overweight and putting a transport sub-index on upgrade watch. Stick With Software Stocks The S&P software index is on the cusp of breaching the 2000 relative performance all-time peak, and we reiterate the high-conviction overweight status of this key tech sub-index, that is up over 11% versus the SPX since the late-November inception.1 Although this may appear exuberant, from a longer-term perspective, relative share prices only recently reclaimed the upward sloping historical time trend mean (top panel, Chart 5). The implication is that more gains are in store prior to the end of the business cycle. BCA's synchronized global capex upcycle theme is the fundamental driver of our sanguine software industry view. In the aftermath of the dotcom bust, tech investment in general and software in particular, went into hibernation for a whole decade. Currently, software investment is outpacing overall capital outlays (middle panel, Chart 5). These software capex market share gains on the back of a growing overall capex pie bode well for relative profit growth. Animal spirits remain upbeat with both consumer and most importantly CEO confidence probing multi-year highs. Tack on the still buoyant message from our capex indicator and software spending has more room to grow (second & third panels, Chart 6). In addition, the government sector may also increase spending on IT/software services on the back of easing fiscal policy and beefing up on cybersecurity (Chart 7). Chart 5Buy The Breakout Chart 6Even Uncle Sam Is Buying Software Chart 7Margin Expansion Phase Has Legs While our S&P software EPS growth model corroborates this encouraging news (bottom panel, Chart 5), sell side analysts do not share our optimism. In fact, software profits are forecast to trail the broad market by 500bps, a rather low hurdle. On the operating front, sales are accelerating at a time when labor costs remain contained. Importantly, software prices are on the verge of exiting deflation, underscoring that software demand is robust. Moreover, the secular advance in cloud computing and SaaS represent a long-term positive demand backdrop. The upshot is that the mini margin expansion phase in place since early-2016 has more legs (Chart 7). Meanwhile, the S&P software index has a pristine balance sheet with virtually no net debt, a high interest coverage ratio and galloping higher free cash flow (Chart 8). Unsurprisingly, this cash rich tech subsector has also been in the middle of an M&A frenzy. This supply reduction is not only bullish for industry pricing power, and thus profit growth, but it has also led to hefty M&A premia and a significant valuation rerating (bottom panel, Chart 9). Chart 8Pristine Balance Sheet Chart 9Software Will Grow Into Pricey Valuations If our virtuous capex upcycle thesis further bolsters software sales/profits in the coming months, then more gains are in store for the S&P software index that will likely grow into its pricey valuations. Bottom Line: We reiterate our high-conviction overweight status in the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, RHT, ADSK, CTXS, ANSS, SNPS, SYMC, TTWO, CDNS, CA. Could Jet Fuel Be The Tailwind Airlines Need? It is a well-established rule that where jet fuel prices go, airline stock prices will go the opposite direction. Thus it is no surprise that the most recent peak in the S&P airlines index coincided with the most recent trough in jet fuel prices in early 2017; the former has since fallen steeply as the latter has soared (top panel, Chart 10). This relationship has grown more acute as the industry, having been burned when fuel prices collapsed in 2014, has all but abandoned fuel hedging. The timing for rising jet fuel prices could scarcely be less opportune; historically, airlines have been able to pass through rising fuel costs. Now, in the midst of an industry price war, pricing power and fuel costs are diverging (second panel, Chart 10). The impact is apparent on industry margins, which have been in decline for nearly two years and more pain likely lies ahead (second panel, Chart 11). The head of airline industry group International Air Transport Association (IATA), recently noted that rising oil prices would significantly bite into airline profitability next year; IATA is widely expected to lower its industry benchmark profit forecast this week. Chart 10Mind The Gap Chart 11Acute Margin Trouble... The source of industry conflict has been an uptick in capacity growth. Airlines are adding capacity faster than the economy is growing (third and fourth panels, Chart 11) and the only relief valve to preserve market share is to cut prices. In this context, it is difficult to understand analysts' 20%+ EPS growth forecast for next year, significantly outpacing the S&P 500 (bottom panel, Chart 11). However, the news is not all bad. Despite the competitive headwinds, the industry has been successful at moving unit revenues higher and airlines have been doing so at an aggressive pace in 2018 (second panel, Chart 12). Further, industry load factors (in essence, the percentage of filled seats) are near their highest level ever, indicating capacity growth is being met with lower price-induced demand growth (bottom panel, Chart 12). Rising load factors are typically a precursor to price (and profit) increases. Investors appear to have capitulated. Airlines trade at roughly half the market multiple on an EV/EBITDA basis and a substantial discount on a price/book basis (second & third panels, Chart 13). From a valuation perspective, airlines look set to take off. Chart 12...But Demand is Firming... Chart 13...And Most Bad News Is Likely Priced In Easing oil prices are a likely catalyst for a significant rerating in depressed relative valuations. Fuel hedges no longer play a significant role in earnings and lower fuel costs would translate directly to the bottom line. As a reminder, nearly all major players reiterated their pledge to avoid kerosene hedging earlier this year. Adding it up, we think downside risks to airlines have abated considerably and are well reflected in beaten down valuations. We are therefore compelled to add this transportation sub-index to our upgrade watch list. If there is any letup in jet fuel prices, we would not hesitate to crystallize relative profits north of 21% since our underweight inception. Bottom Line: Stay underweight the S&P airlines index for now, but put in on upgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Overweight (High-Conviction) The S&P software index caught a bid last week, led by heavyweight Microsoft (representing a bit more than 50% of the index) following a positive sell-side report that put a one-year price target implying a $1 trillion market cap. The basis for the (very) high expectations was Microsoft's dominant position in cloud computing and its rapid adoption in the marketplace; we are very much in agreement as we believe software spending is in the early days of an acceleration. CEO confidence, despite having peaked, remains near decade-highs, typically a precursor of greater software spending (second panel). Bank loan growth, another leading indicator of loosening purse strings, has just turned a corner (third panel). Our optimism is clearly shared by the analyst consensus view as earnings revisions have reached a seven-year high (bottom panel). Adding it up, we think more outperformance is in store for this technology subsector; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, TTWO, CA, CDNS.

Highlights Portfolio Strategy Synchronized global capex growth and higher interest rates are two key themes that will continue to dominate this year. Three high-conviction calls are levered to the former theme and two to the latter. A special situation completes our sextet. Reinstate the S&P construction machinery & heavy truck index to the high-conviction overweight list. We also reiterate our high-conviction underweight call in the newcomer S&P telecom services sector. Recent Changes S&P Construction Machinery & Heavy Truck - Add back to high-conviction overweight list. Table 1 Feature Chart 1Market Bounced Smartly Equities regained their footing last week, as volatility took a breather. There are high odds that the technical, mostly-sentiment driven, pullback that we have been flagging since January 22nd is nearly over, as the market smartly bounced off the 200-day moving average (top panel, Chart 1).1 A consolidation/absorption phase is looming and, according to our "buy the dip" cycle-on-cycle analysis, a retest of the recent lows is likely before the market gets out of the woods (please refer to Chart 1 from last week's publication). While inflation expectations, crude oil prices and financial conditions are all tightly linked with and weighing on the S&P 500 (second and third panels, Chart 1), a number of tactical high-frequency financial market indicators suggest that the cyclical SPX bull market remains intact. First, SPX e-mini futures positioning is an excellent leading indicator of market momentum, and the current message is positive (net speculative positions are advanced by 40 weeks, Chart 2). Second, bond market internal dynamics suggest that this mini "risk off" episode is an isolated one and not a precursor to a real tremor. The high yield bond ETF outperformed the long dated Treasury bond ETF (bottom panel, Chart 3). It would be unprecedented for an equity market downdraft to morph into a fully blown bear market without junk bonds sinking compared with the ultimate risk free asset. Even when adjusted for its lower duration, the high yield bond ETF remained resilient versus the 3-7 year Treasury bond ETF (top panel, Chart 3). Chart 2Futures Positioning... Chart 3...Junk Bonds... Third, the calmness in the TED spread corroborates the message from the bond market. Were a systemic risk to materialize, the TED spread should have widened and not come in as it did in the past two weeks (Chart 4). Put differently, quiet interbank markets are a healthy sign. Chart 4...And TED Spread All Flashing Green Finally, relative valuations have corrected not only on an absolute basis (please refer to the bottom panel of Chart 2A from last week's Report), but also controlled for equity market volatility. In fact, Chart 5 shows that both the VIX-adjusted Shiller P/E and the 12-month forward P/E have returned to the neutral zone. Meanwhile, two key macro indicators we track are also flashing green. Chart 6 shows momentum in money velocity or how fast "one unit of currency is used to purchase domestically-produced goods and services".2 Historically, velocity of M2 money stock has been positively correlated with stock market momentum. The recent spike in this indicator suggests that the longevity of the business cycle remains intact, and investors with a cyclical (9-12 month) investment horizon should start "buying the dip", as we suggested on February 8th.3 Another yield curve-type macro indicator confirms this buoyant business cycle message: real GDP growth is easily outpacing real interest rates, as per the 10-year TIPS market (Chart 7). In other words, real rates are not yet restrictive enough to choke off GDP growth, despite the recent 35bps increase. Were this spread to plunge below the zero line, it would predict recession. Thus, the recent widening underscores that recession is not imminent. Chart 5Valuations Return To Earth Chart 6Money Velocity... Chart 7...And Yield Curve Emit Bullish Signal Under such a backdrop, the upshot is that earnings will remain upbeat in 2018 and continue to underpin equity prices. This week we revisit our 2018 high-conviction call list and reinstate one sector to the overweight column. Chart 8Both Themes Remains Intact The Themes Two key BCA themes formed the cornerstone of our 2018 high conviction call list: Synchronized global capex upcycle Higher interest rates Last autumn, we started to articulate the synchronized global capital spending macro theme4 that, despite still flying under the radar, will likely dominate this year. Both advanced and emerging economies are simultaneously expanding gross fixed capital formation (middle panel, Chart 8). As a result, we reiterate our cyclical over defensive portfolio bent,5 and continue to tie three high-conviction overweight calls to this theme. Similarly, late last year we started to highlight BCA's U.S. Bond Strategy view of a higher 10-year yield on the back of rising inflation expectations for 2018 (bottom panel, Chart 8). Back in late-November we posited that if BCA's constructive crude oil view pans out then inflation and rates may get an added boost. Two high-conviction calls remain levered to this theme. Finally, a special situation rounds up our call this year. But before we update the call list and make a small tweak, a quick housekeeping note is in order. Taking The Tally Early this year, we added trailing stops to our high-conviction call list as a risk management tool. The goal was to help protect profits as a number of our calls were showing outsized gains for such a short time span. Our tactically souring view of the overall market also compelled us to introduce this risk management metric. As a result of the recent careening in the SPX, half of our calls got stopped out with lofty double digit gains since inception a mere two and a half months ago. Namely, our speculative underweights in the S&P semi equipment and S&P homebuilders registered gains of 20% and 10%, respectively. The high-conviction underweight in the S&P utilities sector got called at an 18% gain, and our high-conviction overweight call in the S&P construction machinery & heavy truck (CMHT) index got stopped out at the 10% mark. (Please refer to page 15 for the closed trades table). Last week we added the S&P telecom services sector as a high-conviction underweight replacing the S&P utilities sector, and now that the worst is likely behind us, we are reinstating the S&P CMHT index to the high-conviction overweight list. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Construction Machinery & Heavy Truck (Overweight, Capex Theme) The capex upcycle is underpinning machinery stocks. Not only are expectations for overall capital outlays as good as they get (Chart 9), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. While we are not calling for a return to the previous cycle's peak, even a modest renormalization of capital spending plans in these two key machinery client segments would rekindle industry sales growth. Recent news of oil majors accelerating their capex plans is a step in the right direction. This machinery end-demand improvement is not only a U.S. phenomenon, but also a global one. The middle panel of Chart 9 shows Caterpillar's global machinery sales to dealers hitting a decade high. Tack on the drubbing in the U.S. dollar and related commodity price inflation and the ingredients are in place for a global machinery export boom. While most of the countries we track enjoy a sizable rebound in machinery orders, Japan's machine tools orders have surged to an all-time high confirming that machinery global end demand is brisk (bottom panel, Chart 9). Finally, our machinery EPS model is firing on all cylinders, underscoring that the earnings-led recovery has more running room (fourth panel, Chart 9). Reinstate the S&P CMHT index to the high-conviction overweight list. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Energy (Overweight, Capex Theme) The S&P energy sector is a key beneficiary of our synchronized global capex theme. The Dallas Fed manufacturing outlook survey is firing on all cylinders and, given the importance of oil to the state of Texas, it serves as an excellent gauge for oil activity. Importantly, the capital expenditures part of the survey hit its highest level in a decade, and capex intentions in the coming six months are also probing multi-year highs. The overall message is that the budding recovery in energy capital budgets will likely gain steam (second panel, Chart 10). Following the late-2015/early-2016 drubbing in oil prices, energy projects ground to a halt and only now are green shoots appearing (middle panel, Chart 10). Recent news that Exxon Mobil would bump domestic capital spending up to $50bn over the next five years is encouraging. New projects/investments comprise 70% of this figure. OECD oil stocks are receding steadily and so are U.S. crude oil inventories. OPEC 2.0 remains in place and will likely balance the oil market by continuing to constrain supply. Our Commodity & Energy Strategy service is still penciling in higher oil prices for 2018. On the demand side, emerging markets/Chinese demand is the key determinant of overall oil demand, and the news on this front is encouraging and consistent with BCA's synchronized global growth theme: following the recent lull, non-OECD demand is growing anew by roughly 1.5mn bbl/day. The upshot is that S&P energy relative revenues will climb out of the recent trough (bottom panel, Chart 10). The ticker symbols for the stocks in this index are: BLBG: S5ENRS - XLE: US. Chart 9Construction Machinery & Heavy Truck ##br##(Overweight, Capex Theme) Chart 10Energy (Overweight, Capex Theme) Software (Overweight, Capex Theme) The S&P software index is another clear capex upcycle beneficiary. If software commands a larger slice of the overall capital spending pie as we expect, then industry profits should enjoy a healthy rebound (second panel, Chart 11). Small business sector plans to expand keep on hitting fresh recovery highs, underscoring that software related outlays will likely follow them higher. Rebounding bank loan growth also corroborates the upbeat spending message and signals that businesses are beginning to loosen their purse strings (Chart 11). Reviving animal spirits suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs (middle panel, Chart 11). Such ebullience is positive for a pickup in software outlays. It has also rekindled software M&A activity, and pushed take out premia higher. Meanwhile, the structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Tax reform is another bonus for this group that benefits from cash repatriation, which will likely result in increased shareholder friendly activities. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, CA. Banks (Overweight, Higher Interest Rates Theme) The S&P banks index remains a core overweight portfolio holding and there are high odds of additional relative gains in the coming quarters beyond the current 10% relative return mark since the November 27th, 2017 inception. All three key drivers of bank profits, namely price of credit, loan growth and credit quality, are simultaneously moving in the right direction. On the price front, BCA expects the 10-year yield will continue to rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think that inflation expectations have more room to run, likely pushing the 10-year Treasury yield close to 3.25% (top panel, Chart 12). C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM remains squarely above the 50 boom/bust line and consumer confidence is still buoyant. Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (third panel, Chart 12). Finally, credit quality remains pristine despite some pockets of weakness in auto loans (especially subprime) and credit card debt. At this stage of the cycle, with a closed unemployment gap, NPLs will remain muted. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.  Chart 11Software (Overweight, Capex Theme) Chart 12Banks (Overweight, Higher Interest Rates Theme) Telecom Services (Underweight, Higher Interest Rates Theme) We downgraded the S&P telecom services index to underweight and added it to the high-conviction underweight list last week, filling the void left by the S&P utilities sector.6 Three main reasons are behind our dislike for this fixed income proxy sector: BCA's 2018 rising interest rate theme, both our Cyclical Macro Indicator (CMI) and our sales model send a distress signal, and a profit margin squeeze is looming. The top panel of Chart 13 shows that high dividend yielding telecom services stocks and the 10-year yield are nearly perfectly inversely correlated. In fact, telecom services stocks are prime beneficiaries of disinflation/deflation and vice versa. BCA's bond market view remains that the 10-year yield will continue to rise likely piercing through 3% and weigh heavily on this fixed income proxied sector. Our CMI has melted and relative consumer outlays on telecom services have also taken a nosedive (second & third panels, Chart 13), warning that revenue growth will be hard to come by for telecom carriers. In fact, while nearly all of the GICS1 sectors have come out of the top line growth lull of late-2015/early-2016, telecom services sales growth has relapsed. Worrisomely, our S&P telecom services revenue growth model remains deep in contractionary territory, waving a red flag (bottom panel, Chart 13). Finally, still steeply deflating selling prices are a major headwind for the sector's top and bottom line growth prospects and coupled with a still expanding wage bill, suggest that a profit margin squeeze is looming. The ticker symbols for the stocks in this index are: VZ, T, CTL. Pharmaceuticals (Underweight, Special Situation) Weak pricing power fundamentals, a soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics will sustain downward pressure on pharma stocks. Industry selling prices remain soft (Chart 14). In the context of a bloated industry workforce, the profit margin outlook darkens significantly. If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, as we expect, then industry margins will remain under chronic downward pressure. Our dual synchronized global economic and capex growth themes bode ill for this safe haven index. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the elevated ISM manufacturing index is signaling that pharma profits will underwhelm in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, second panel, Chart 14). A depreciating currency is also synonymous with pharma profit sickness (bottom panel, Chart 14). While pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases, they are still contracting (middle panel, Chart 14), warning that global pharma demand is ill. Finally, even on the operating metric front, the outlook is dark. Pharma industrial production is nil and our productivity proxy remains muted, warning that the valuation derating phase is far from over. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. Chart 13Telecom Services ##br##(Underweight, Higher Interest Rates Theme) Chart 14Pharmaceuticals ##br##(Underweight, Special Situation) 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. 2 https://fred.stlouisfed.org/series/M2V 3 Please see BCA U.S. Equity Strategy Insight, "Buy The Dip," dated February 8, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible," dated November 6, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Manic Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).