Market Capitalization: Large / Small

Remain Timid In Large Caps Remain Timid In Large Caps Neutral We recently capitalized gains of 37% in our size bias and moved to neutral in the S&P 500 / S&P 600 share price ratio as our 10% rolling stop was hit. In addition, in the most recent Weekly Report we highlighted a number of improvements for US small caps: peaking relative job proxy, bottomed profit margins, and crested indebtedness. Today, we also add a historical angle to the picture. The chart highlights US large and small caps average performance during the top 10 steepest monthly falls since 1978, as well as the subsequent 1-year average return. Small caps generally underperform their large caps pears by 5% entering a crisis, but outshine large caps by 9% on average in the following 12 months. Bottom Line: Stay neutral the size bias, but stay tuned.  

Highlights Portfolio Strategy An easy Fed as far as the eye can see and World War-like fiscal easing packages as the Trump administration prepares to slowly reopen the economy, signal that the path of least resistance remains higher for the S&P 500 in the coming 9-12 months. Relative indebtedness and profit margin improvements, extremely oversold technicals and significant relative undervaluation along with an encouraging message from financial market indicators, all suggest that it no longer pays to have a large cap bias. Book gains and step aside. Recent Changes Our long S&P 500/short S&P 600 position was stopped out last Tuesday for a 37% gain since inception.1 Last Wednesday our rolling stop was also triggered on the overweight in the S&P managed health care index – it is now neutral – for a gain of 26% since inception.2 Table 1 Things Are Looking Up Things Are Looking Up Feature The SPX made a run for the technically important 200-day moving average last week, and managed to climb to fresh recovery highs before giving back those gains as profit taking intensified late in the week. Three key drivers underpinned stocks and dominated the newsflow: First, resurfacing of positive news on remdesivir, a GILD drug, in treating the novel coronavirus. Second, the Fed reiterating its commitment to ZIRP and QE5 (Chart 1). And third, the quintuplet tech titans (MSFT, AAPL, GOOGL, AMZN & FB) reporting solid profits and April guidance, thus alleviating investors’ fears of a complete breakdown in tech revenues and EPS. Chart 1Easy Central Bank Monetary Policy Stance… Easy Central Bank Monetary Policy Stance… Easy Central Bank Monetary Policy Stance… Tack on the World War-like fiscal easing packages (Chart 2) and the path of least resistance remains higher for the S&P 500 in the coming 9-12 months. Chart 2…And An Easier Fiscal Policy Setting Are A Boon For Stocks …And An Easier Fiscal Policy Setting Are A Boon For Stocks …And An Easier Fiscal Policy Setting Are A Boon For Stocks Granted all of these monies are finding their way into the markets not only via higher asset prices, but also – and most crucially – the Fed’s massive liquidity injection is suppressing volatility. First, Fed actions have crushed the bond market’s vol, as depicted by Bank Of America’s MOVE index, that has now crumbled to a level last seen prior to the equity market drubbing. Similarly, the Fed has also quashed the VIX index which is now hovering near 35, down from a peak of 85 last month. Importantly, volatility petered out prior to the equity market’s trough, and so did different volatility curves (volatilities and volatility curve shown inverted, Chart 3). Turning over to S&P 500 net earnings revisions (NER), this mean reverting series was first tracked by I/B/E/S in 1985, and two weeks ago collapsed to the nadir of the GFC (Chart 4). Every time the NER ratio has hit such depressed levels, stocks have subsequently staged a powerful comeback. This has occurred five distinct times in the past 35 years and the SPX was 15% higher on average in the following twelve months (Chart 4). Chart 3Vols Lead On The Way Up And Down Vols Lead On The Way Up And Down Vols Lead On The Way Up And Down   Chart 4Extremely Depressed Net Earnings Revisions Have Troughed Extremely Depressed Net Earnings Revisions Have Troughed Extremely Depressed Net Earnings Revisions Have Troughed Drilling deeper beneath the surface is revealing. Analysts have been indiscriminately downgrading profits across all sectors. True, last week’s update revealed a tick up, which is an encouraging sign that the avalanche of downgrades may have already hit a climax (Charts 5 &  6). Chart 5Too Much Pessimism… Too Much Pessimism… Too Much Pessimism… Chart 6…Across The Board …Across The Board …Across The Board Importantly, our in-house calculated SPX sector EPS breadth is probing all-time lows. But, if the Fed manages to devalue the US dollar then a sharp reversal will ensue. Keep in mind, that the greenback and our EPS breadth indicator are inversely correlated as 40% of SPX sales are sourced internationally (Chart 7). Chart 7As Bad As It Gets As Bad As It Gets As Bad As It Gets Finally, a few words on the character of the equity market’s advance since the March 23 lows are in order. Contrary to popular belief, this has been an extremely broad based rally and the stocks that have done the best are not the large/mega caps. Instead the median stock has far outpaced the top market cap ranked constituents. In other words, the stocks that have rebounded the most are the ones that had fallen the most. Using Bloomberg data on SPX constituents from the March 23 lows until April 28, the first mega cap company that makes it to the top return ranks is CVX at the 22nd spot. UNH is 85th, ABT 90th and XOM 132nd. The tech titans start appearing below the 350th mark with MSFT 353rd, AAPL 362nd, FB 370th, AMZN 394th and GOOGL 439th. In other words, both the Value Line Arithmetic and Geometric indexes have been outperforming the SPX since the March 23 lows (top & middle panels, Chart 8). Similarly, small caps have also been besting the SPX (bottom panel, Chart 8). Notably, all three of these hypersensitive indexes have also led the SPX bottom. This week, we update our size view that was stopped out last Tuesday as the rolling stop was triggered for a gain of 37% since inception, and do some housekeeping. Chart 8Broad Based Rally Broad Based Rally Broad Based Rally Lock In Profits In the Size Bias And Move To The Sidelines In the spring of 2018 we initiated a size preference of large caps at the expense of small caps. At the time, we went against the grain as the investment community was arguing that small caps would offer the best protection from President’s Trump trade hawkishness. Their reasoning was that small caps are domestically oriented and would benefit from a rising dollar given low export exposure. While we were slightly offside for a quarter, this size preference recouped all the losses by October 2018, and never looked back since then. Our thesis was predicated upon relative indebtedness, relative profitability and relative profit margin outlook, all of which were in favor of large caps. Earlier this year when markets were convulsing we instituted a risk management metric with a rolling 10% stop on this size preference in order to protect profits for our portfolio.3 This past Tuesday our 10% rolling stop was triggered and we are obeying this stop, monetizing 37% gains since inception and we are moving to the sidelines on the size bias (Chart 9). Chart 9Take Profits And Move To The Sidelines Take Profits And Move To The Sidelines Take Profits And Move To The Sidelines Following a near collapse to two standard deviations below the six year mean, small cap performance has returned to the mean and is primed to sustain this reflex rebound. In marked contrast, large caps only corrected to their six year average and are now trading at over one standard deviation above that mean (Chart 10). When the economy was shut down small and medium businesses were clearly the outfits that would hurt the most. Their only rescue came belated in the form of the fiscal package. Thus, investors started pricing in a steep default cycle with SMEs at the forefront of the bankruptcy curve (top panel, Chart 10). In contrast, large caps with access to untapped credit lines, the bond and equity markets as well as their own cash coffers would not suffer as severely (second panel, Chart 10). Chart 10Large Cap Outperformance Reached An Extreme Large Cap Outperformance Reached An Extreme Large Cap Outperformance Reached An Extreme Now that the economy is on the verge of slowly reopening, we do not want to overstay our welcome and refrain from betting on a further jump in the large/small ratio; instead we opt to book profits and move to the sidelines. With regard to profit fundamentals, our relative jobs proxy has peaked and is no longer favoring large caps (second panel, Chart 11). Similarly, profit margins have likely bottomed for small caps while they have maxed out for large caps (third panel, Chart 11). On the relative indebtedness front, small cap net debt-to-EBITDA remains sky high but it has crested which is at the margin positive (bottom panel, Chart 11). Meanwhile, as the Fed has opened up the liquidity spigots, the government is as spendthrift as it can be and committed to slowly reopen the economy, then at some point in the summer the pendulum will swing the opposite way and some semblance of normality will return to the US economy. Therefore, this inflection point will end the threat of deflation and likely serve as a catalyst for a small/large multiple expansion phase (Chart 12). Chart 11Marginal Small Cap Improvements Marginal Small Cap Improvements Marginal Small Cap Improvements Chart 12When The Economy Turns, So Will Small Caps When The Economy Turns, So Will Small Caps When The Economy Turns, So Will Small Caps With regard to the message that financial market variables are sending for the small/large ratio, the collapse of the VIX is a welcome development (VIX shown inverted, Chart 13). Similarly, the yield curve has been in steepening mode again emitting a positive “risk on” signal. Under such a backdrop and given depressed technicals and bombed out valuations it is prudent not to wager against small caps at this juncture (Chart 14). Chart 13Leading Financial Market Indicators Say Do Not Overstay Your Welcome Leading Financial Market Indicators Say Do Not Overstay Your Welcome Leading Financial Market Indicators Say Do Not Overstay Your Welcome Chart 14Unloved And Undervalued Unloved And Undervalued Unloved And Undervalued Netting it all out, relative indebtedness and profit margin improvements, the slow reopening of the economy in the coming months, extremely oversold technicals and significant relative undervaluation along with an encouraging message from financial market indicators, all signal that it no longer pays to have a large cap bias. Bottom Line: Move to the sidelines on the size bias and crystalize profits of 37% since inception. Housekeeping Last Wednesday our rolling stop was also triggered on the overweight in the S&P managed health care index – it is now neutral – for a gain of 26% since inception (top panel, Chart 15).4 In addition, we are stepping aside from the COVID-proof basket of stocks we recommended six weeks ago.5 The coronavirus unintended consequences will alter government, business and consumer behaviors and it will most definitely affect consumer tastes, underscoring that the companies that comprise our COVID profit basket will likely be long-term winners. However, this basket has served its purpose and given that the global economy is on the verge of reopening it will be increasingly difficult to outperform the broad market. Thus, we are moving to the sidelines for a modest relative gain of 0.8% (second & third panels, Chart 15). Finally, our freshly minted market-neutral and intra-commodity long S&P oil & gas exploration & production/short global gold miners pair trade has gone parabolic right out of the gate soaring to 20% in a mere week. As a result of this explosive up-move, we are instituting a 10% rolling stop in this pair trade in order to protect profits for our portfolio (bottom panel, Chart 15). Chart 15Housekeeping Housekeeping Housekeeping     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1    Please see BCA US Equity Strategy Daily Report, “Book Gains In Preferring Large Caps To Small Caps” dated April 30, 2020, available at uses.bcaresearch.com. 2    Please see BCA US Equity Strategy Daily Report, “Take Profits In HMOs And Move To The Sidelines” dated May 1, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Daily Report, “Closing Out All High-Conviction Calls” dated March 20, 2020, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Daily Report, “Take Profits In HMOs And Move To The Sidelines” dated May 1, 2020, available at uses.bcaresearch.com. 5    Please see BCA US Equity Strategy Daily Report, “Corona Virus Proof Portfolio” dated March 18, 2020, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Things Are Looking Up Things Are Looking Up Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth April 28, 2020  Stay neutral large over small caps  June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

In the spring of 2018 we initiated a size preference of large caps at the expense of small caps. At the time, we went against the grain as the investment community was arguing that small caps would offer the best protection from President’s Trump trade hawkishness. The reasoning was that small caps are domestically oriented and would benefit from a rising dollar given low export exposure. While we were slightly offside for a quarter, this size preference recouped all the losses by October 2018 and never looked back since then. Our thesis was predicated upon relative indebtedness, relative profitability and relative profit margin outlook, all of which were in favor of large caps. Earlier this year when markets were convulsing we instituted a risk management metric with a rolling 10% stop on this size preference in order to protect profits for our portfolio.1 Bottom Line: This past Tuesday our 10% rolling stop was triggered and we are obeying this stop, monetizing 37% gains since inception and we are moving to the sidelines on the size bias. Please look forward to reading our upcoming Weekly Report for a more detailed discussion of why we are compelled to move to a neutral size bias. Book Gains In Preferring Large Caps To Small Caps Book Gains In Preferring Large Caps To Small Caps Footnotes 1    Please see BCA US Equity Strategy Daily Report, "Closing Out All High-Conviction Calls" dated March 20, 2020, available at uses.bcaresearch.com.

Watching Market Internals Watching Market Internals Equity market bloodletting likely reached a climax last Thursday as indiscriminate selling pushed correlations to the extremes of +/-1. Since then however, hypersensitive stocks have made an attempt for a comeback. These greenshoots are most visible in the highest beta areas of the market, namely chip stocks and small cap indexes. The chart shows that both the Philly SOX index and the Russell 2000 are ticking higher versus the NASDAQ 100 and S&P 500 indexes, respectively. While it is still too soon to call the ultimate trough in stocks and a retest will likely materialize, it is encouraging that investors are no longer pressing the panic sell button. Tack on the extreme short interest and lack of depth in ES futures and a significant short-covering reflex rally is likely to continue in the coming days.  Bottom Line: We recommend investors with higher risk tolerance and a 9-12 month cyclical time horizon to continue nibbling on the broad equity market.​​​​​​​

Unhinged Unhinged There is a lot of uncertainty that reverberates through the equity markets and the dust has yet to settle down from Monday’s big crack. Small caps (similar to weak balance sheet stocks, middle panel) have cratered for three reasons: First, they are massively indebted as the bottom panel of the chart shows not only in absolute terms, but also compared with their large cap brethren. Second, small caps have been mired in earnings deflation for a while and the looming recession now aggravates the fall in these high beta stocks. Finally, small caps have a large weighting in financials in general and small regional banks in particular. As such, the recent double whammy of the oil price collapse and bond yield plunge has wreaked havoc in small cap indexes. We have been cyclically avoiding small caps and instead preferring large caps since mid-2018 and late-last year we also added this size preference to our high-conviction call list as a modest hedge to most other high-conviction calls that were levered to higher interest rates. Today, from a portfolio risk management perspective, we are instituting a trailing stop at the 10% return mark in order to protect gains. Bottom Line: Stick with the large cap bias for a while longer.  

Cyclical & High-Conviction Overweights Both our cyclical and 2020 high-conviction large caps overweights versus small caps are in the black by 20% and 5%, respectively, since inception. Debt-saddled small caps have been left behind this cycle as they are more than twice as leveraged compared with their large caps peers on a net debt-to-EBITDA basis. Meanwhile, the narrative that small caps have cheapened versus large caps also does not hold as index providers omit negative profits from their forward EPS calculations. Adjusting for that, small caps are dearly priced versus the SPX. Finally, our relative sentiment proxy gauging the relative attractiveness of small caps versus large caps is on the verge of  crossing below the zero line, underscoring that investors should stick with a large cap bias. Bottom Line: We reiterate our large cap preference at the expense of small cap stocks. Stick With A Large Cap Bias Stick With A Large Cap Bias

Feature The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Every decade a dominant theme captures investors’ imaginations and morphs into a bubble. Massive speculation typically propels the relevant asset class into the stratosphere as investors extrapolate the good times far into the future and go on a buying frenzy. Chart 1 shows previous manic markets starting with the Nifty Fifty, gold bullion, the Nikkei 225, the NASDAQ 100, crude oil and most recently the FAANGs. Chart 1Manias: An Historical Roadmap Manias: An Historical Roadmap Manias: An Historical Roadmap What will be the dominant themes of the next decade? How should investors capitalize on some of these big trends? The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Theme #1: De-Globalization Picks Up Steam The first investment theme for the upcoming decade is the “apex of globalization” or “de-globalization”. We have written about this theme extensively at BCA Research and it is the mega-theme of our sister Geopolitical Strategy (GPS) service. Odds are high that countries will continue looking inward as the US adopts a more aggressive trade policy, China’s trend growth slows, and US-China strategic tensions intensify. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Chart 2 shows that we are at the conclusion of a period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. The US is in a relative decline after decades of geopolitical stability allowed countries like China to rise to “great power” status and rivals like Russia to recover from the chaos of the 1990s. Chart 2De-globalization Has Commenced De-globalization Has Commenced De-globalization Has Commenced De-globalization has become the consensus since the election of Donald Trump. But Trump is not the prophet of de-globalization; he is its acolyte. Globalization is ending because of structural factors, not cyclical ones. And its decline was pre-written into its “source code.” Three factors stand at the center of this assessment, outlined in our 2014 Special Report, “The Apex Of Globalization – All Downhill From Here”: multipolarity, populism and protectionism. Events have since confirmed this view. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Investment Implication #1: Profit Margin Peak The most profound and provocative investment implication from de-globalization is that SPX profit margins have peaked and will likely come under intense pressure, especially for US conglomerates that – on a relative basis to international peers – most enthusiastically embraced globalization. Reconstructed S&P 500 profits and sales data date back to the late-1920s. Historically, corporate profit margins and globalization (depicted as global trade as a percentage of GDP) have been positively correlated (Chart 3). Chart 3Profit Margin Trouble Profit Margin Trouble Profit Margin Trouble As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit-maximizing projects. Following the Great Recession and similar to the Great Depression, trade has suffered and trade barriers have risen. The Sino-American trade war has accelerated the inward movement of countries, including Korea and Japan, and has had negative knock-on effects on trade as evidenced by the now two-year old global growth deceleration. China’s response to President Trump’s election was to redouble its pursuit of economic self-sufficiency, which meant a crackdown on corporate debt and a fiscal boost to household consumption. Trump’s tariffs then damaged sentiment and trade between the two countries. Any deal reached prior to the 2020 US election will remain in doubt among global investors. The longer the trade war remains unresolved, the deeper the cracks will be in the foundations of the global trading system. Such a backdrop is negative for profit margins, as inward looking countries prevent capital from being allocated most efficiently. Moreover, the uprooting of supply chains due to the trade war hurts margins and the redeployment of equipment in different jurisdictions will do the same at a time when final demand is suffering a setback. In addition, rising profit margins are synonymous with wealth accruing to the top 1% of US families and vice versa. This relationship dates back to the late-1920s, as far back as our dataset goes. Using Piketty and Saez data, which exclude capital gains, it is clear that profit margin expansion exacerbates income inequality (top panel, Chart 4). Chart 4Heightened Risk Of Wealth Re-distribution Heightened Risk Of Wealth Re-distribution Heightened Risk Of Wealth Re-distribution Expanding margins lead to higher profits. Because families at the top of the income distribution are more often than not business owners, income disparities are the widest when margins are in overshoot territory. Eventually this income chasm comes to a head and generates political discontent. Populism has emerged on both the right and left wings of the US political spectrum – and since the rise of Trump, even Republicans complain about inequality and the excesses of “corporate welfare” and laissez-faire capitalism. Because inequality is extreme – relative to America’s developed peers – and political forces are mobilizing against it, the probability of wealth re-distribution is rising in the coming decades (middle panel, Chart 4). Labor’s share of national income has nowhere to go but higher in coming years and that is negative for profit margins, ceteris paribus (bottom panel, Chart 4). Drilling beneath the surface, the three secular US equity sector/factor implications of the apex of globalization paradigm shift are: prefer small caps over large caps prefer value over growth overweight the pure-play BCA Defense Index Investment Implication #2: Small Is Beautiful While a small cap bias is contrary to the cyclical US Equity Strategy view of preferring large caps to small caps, the issue is timing: the small cap preference is a secular view with a time horizon that spans the next decade. The small versus large cap share price ratio’s ebbs and flows persist over long cycles. Small caps outshined large caps uninterruptedly from 1999 to 2010. Since then large caps have had the upper hand (Chart 5). Were the apex of globalization theme to gain traction in the 2020s, small caps should reclaim the lead from large caps, especially in the wake of the next US recession. Similar to the death of the global banking model, companies with global footprints will suffer the most, especially compared with domestically focused outfits. One way to explore this theme is via domestic versus global sector preference. But a more investable way to position for this sea change, is to buy small caps (or microcaps) at the expense of large caps (or mega caps). Small caps are traditionally domestically geared compared with large caps that have significantly more foreign sales exposure. Chart 5It’s A Small World After All It’s A Small World After All It’s A Small World After All The closest ETF ticker symbols resembling this trade is long IWM:US/short SPY:US. Investment Implication #3: Buy Value At The Expense Of Growth Similar to the size bias, the style bias also moves in secular ways. Value outperformed growth from the dot com bust until the GFC. Since then growth has crushed value, even temporarily breaking below the year 2000 relative trough. This breakneck pace of appreciation for growth stocks is clearly unsustainable and offers long-term oriented investors a compelling entry point near two standard deviations below the historical mean (Chart 6). Chart 6Value Has The Upper Hand Versus Growth Value Has The Upper Hand Versus Growth Value Has The Upper Hand Versus Growth Financials populate value indexes, a similarity with small cap outfits. Traditionally, financials are a domestically focused sector with export exposure registering at half of the S&P’s average 40% level of internationally sourced revenues. On the flip side, tech stocks sit atop the growth table and they garner 60% of their revenue from abroad. This value over growth style preference will pay handsome dividends if the de-globalization theme becomes more main stream as countries become more hawkish on trade and the Sino-American war continues to erect barriers to trade that took decades to lift. The caveat? If President Trump strikes a short-term deal with China ahead of the 2020 election, the de-globalization theme will suffer a setback. But our geopolitical strategists expect a ceasefire at best, not a durable deal, and also expect the trade war to resume in some way, shape or form in 2021-22, regardless of the outcome of the US election. The closest ETF ticker symbols resembling this trade is long IVE:US/short IVW:US.  Investment Implication #4: Defense Fortress One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks (Chart 7). Our October 2016 “Brothers In Arms” Special Report drew parallels with the late nineteenth century period of European rearmament, and the American and Soviet arms race of the 1960s. These movements were greatly beneficial to the aerospace and defense industry. Currently, the move by several countries to adopt more independent foreign policies, i.e. to move away from collaboration and cooperation toward isolationism and self-sufficiency, entails an accompanying arms race. Chart 7Stick With Pure-play Defense Stocks Stick With Pure-play Defense Stocks Stick With Pure-play Defense Stocks Table 1 Top US Sector Investment Ideas For The Next Decade Top US Sector Investment Ideas For The Next Decade China’s challenge to the regional political status quo motivates a boost to defense spending globally. In fact SIPRI data on global military spending by 2030 (Table 1) increases our conviction that this trade will succeed on a five-to-ten year horizon. Beyond the global arms race, two additional forces are at work underpinning pure-play defense contractors. A global space race with China, India and the US wanting to have manned missions to the moon, and the rise of global cybersecurity breaches. Defense companies are levered to both of these secular forces and should be prime sales and profit beneficiaries to rising space budgets and increasing cybersecurity combat budgets. The ticker symbols for the stocks in the pure-play BCA defense index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY. Theme #2: Tech Sector Regulation, US Enacts Privacy Laws The second long-term geopolitical theme that we are exploring is the regulatory or “stroke of pen” risk that is rising on FAANG stocks – Facebook, Apple, Amazon, Netflix, and Google. These companies were this decade’s undisputed stock market winners. The US 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.” However, through subsequent regulatory evolution, the Chicago School has focused the US anti-trust process on consumer welfare and prices. If President Reagan and the courts could change how anti-trust laws were administered in the 1980s, so too can future administrations and courts. Today the US Congress, on both sides of the aisle, is looking into regulatory tightening, while the judicial system will take longer to change its approach. Moreover, the impetus for tougher anti-trust policy is here. It comes from a long period of slow growth, income inequality, and economic volatility – such as in the 1870s-80s. 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. Today, income inequality is a prominent political theme and source of consumer discontent. A narrative is emerging – which will be super-charged during the next recession – that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. With regard to privacy, the news is equally grim for large tech outfits. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes compliance burdens on any company handling user data. In the US, California has 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, and the US court system is a source of uncertainty, 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 US market of the states. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. The odds of a federal privacy law, following in the footsteps of the Consumer Privacy Act, are also rising. Investment Implication #5: Shun Interactive Media & Services Stocks These risks introduce a severe overhang for FAANG stocks. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Tack on the threat of federal regulation and this represents another major headwind for profits and net profit margins that are extremely elevated for these near monopolies. Given that advertising revenue is crucial to the business model of social media companies (GOOGL and FB included), a significant uptick in privacy regulation will likely hurt their bottom line. With regard to profit margins, tech stocks in general command a profit margin twice as high as the SPX. Specifically, FB and GOOGL enjoy margins that are 500 basis points higher than the broad tech sector (Chart 8)! This is unsustainable and will likely serve as easy prey for policymakers. Our view does not necessarily call for breaking up these monopolies. The US will have to weigh the economic consequences of anti-trust policy in a context of multipolarity in which China’s national tech champions are emerging to compete with American companies for global market share. Nevertheless increased regulation is inevitable and some forced sales of crown jewel assets may take place. Moreover, the threat of a breakup will lurk in the background, creating uncertainty until key legislative and judicial battles have already been fought. That will take years. Finally, we doubt the tech sector will be left alone to “self-regulate” its incumbents and negotiate a price on consumers’ privacy. More likely, a new privacy law will loom overhead, serving as a negative catalyst for profit growth. Uncertainty will weigh on the S&P interactive media & services relative performance. Chart 8Regulation Will Squeeze Tech Margins Regulation Will Squeeze Tech Margins Regulation Will Squeeze Tech Margins The ticker symbols to short/underweight the S&P interactive media & services index are an equally weighted basket of GOOGL and FB (they command a 98% market cap weight in the index). Theme #3: SaaS, Artificial Intelligence, Augmented Reality And Autonomous Driving Are Not Fads The third big theme that will even outlive the upcoming decade is the proliferation of software as a service (SaaS). The move to cloud computing and SaaS, the wider adoption of artificial intelligence, machine learning, autonomous driving and augmented reality are not fads, but enjoy a secular growth profile. In the grander scheme of things today’s world is surrounded by software. Millions of lines of code go even into gasoline powered automobiles, let alone electric vehicles. Autonomous driving is synonymous with software, the Internet of Things (IoT) needs software, the space race depends on software, modern manufacturing and software are closely intertwined, phone calls for quite some time have been a software solution, and the list goes on and on. This tidal effect is hard to reverse and is already embedded in workflows across industries. Opportunities to penetrate health care and financial services more deeply remain unexplored and it is difficult to envision another competing industry unseating “king software”. These secular trends are not only productivity enhancing, but will also most likely prove recession-proof. When growth is scarce investors flock to any source of growth they can come by and we are foreseeing that when the next recession arrives, investors will likely seek shelter in pure play SaaS firms. Investment Implication #6: Software Is Eating The World Buying software stocks for the long haul seems like a bulletproof investment idea. But the recent stellar performance of software stocks that has moved valuations to overshoot territory. Our recommended strategy is to buy or add software stock exposure on any weakness with a 10-year investment time horizon. All of these secular trends have pushed capital outlays on software into a structural uptrend. Software related capex is not only garnering a larger slice of the tech spending budgets but also of the overall capex pie. If it were not for software capex, the contraction in non-residential investment in recent quarters would have been more severe (Chart 9). Private sector software capex is near all-time highs as a share of total outlays. Government investment in software is also reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Cyber security is another more recent source of software related demand as governments around the globe are taking such risks extremely seriously (bottom panel, Chart 9). Given this upbeat demand backdrop and ongoing equity retirement, software stocks are primed to grow into their pricey valuations. Chart 9Software Is Eating The World Software Is Eating The World Software Is Eating The World Finally, this long-term trade will also serve as a hedge to the short/underweight position we recommend in the S&P interactive media & services index. The closest ETF ticker symbol resembling the S&P software index is IGV:US. Theme #4: Millennials Already Are The Largest Cohort And Will Dominate Spending The fourth long-term theme we anticipate will gain traction in the 2020s is the demographic rise of the Millennial generation. Much has been made of preparing for the arrival of the Millennial generation, accompanied by well-worn stereotypes of general "failure to launch" as they reach adulthood. However, "arrival" is a misnomer as this age cohort is already the largest and "failure" is simply untrue. According to the U.S. Census Bureau, Millennials are the US’s largest living generation. Millennials (or Echo Boomers) defined as people aged 18 to 37 (born 1982 to 2000), now number more than 80mn and represent more than one quarter of the US’s population. Baby Boomers (born 1946 to 1964) number about 75mn. Stealthily becoming the largest age group in the US over the last few years, Millennials per-year-birth-rate peaked at 4.3mn in 1990. Surprisingly, the pace matched that of the post-war Baby Boom peak-per-year-birth-rate in 1957 - the per-year average over the period was higher for the Baby Boomers (Chart 10). Chart 10Millennials Are The Largest Cohort Millennials Are The Largest Cohort Millennials Are The Largest Cohort This gap is now set to grow rapidly as the death rate of Baby Boomers accelerates. What is more, the largest one-year age cohort is only 25 years old, thus, Millennials will be the dominant generation for many years. It is unclear how these “kids” will impact the market as they become the most important consumers, borrowers and investors, but make no mistake: this is a seismic shift in economic power and it is here to stay. The Echo Boom is a big, generational demographic wave. A difficult and painful delay has not tempered its looming importance. Finally, this wave of echo-boomers is educated, relatively unburdened by debt (please see BOX in the June 11, 2018 Special Report on demystifying the student debt load as it pertains to Millennials), and as they inevitably “grow up”, form new households and have kids. They will borrow, spend, earn, but not necessarily save and invest to the same extent as the Boomers. And this will be an important long-term theme going forward. Near term we might already be seeing signs of their arrival and firms have begun to pivot accordingly. Investment Implication #7: Buy The BCA Millennials Equity Basket Millennials will boost consumption spending in a number of different ways. The relatively unburdened Millennial cohort will be entering prime home acquisition age soon and this should underpin the long-term prospects of the US housing market and derivative industries. Further, Millennials consume differently from their parents; social media, online shopping and smart phones are not the consumption categories of the Baby Boomers. With this in mind, we have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. We note that these stocks are heavily weighted to the technology and consumer discretionary sectors, which is logical as Millennial consumption habits tend to be discretionary focused and technology-based. Beginning with consumer discretionary, we are highlighting AMZN, NFLX and SPOT as core holdings in our Millennials basket. AMZN’s heft dwarfs consumer discretionary indexes but it could fall in several categories; the acquisition of Whole Foods makes it a Millennials-focused consumer staples retailer and its cloud computing web services segment is a tech leader. NFLX and SPOT represent the means by which Millennials consume media, by streaming movies and music over the internet. The idea of owning physical media is rapidly becoming an anachronism. The home ownership themes noted in the report above lead us to add HD and LEN to the basket. Millennials are “doers” and are set to be the dominant DIYers in the next few years, making HD a logical choice. LEN, as the nation’s largest home builder, should benefit from the Millennials coming of age into home buyers. We are also adding TSLA to our basket as a lone clean tech-oriented equity. TSLA capitalizes on the increasing shift to clean energy of Millennials (the key reason why no traditional energy companies have a spot in our basket). The technology stocks in our Millennials basket are AAPL, UBER (which replaces FB as of today) and MSFT, together representing more than 9% of the total value of the S&P 500. AAPL’s inclusion in the list is predictable as the leading domestic purveyor of devices on which Millennials consume media content. FB is a predictable holding, with more than half of all Americans being monthly active users, dominated by the Millennial cohort. It has served our basket well since inception, but today we are compelled to remove it and replace it with UBER. UBER is a Millennial favorite and the epitome of the sharing economy. In reality UBER is a logistics company and while it is losing money it is eerily reminiscent of AMZN in its early days. Maybe UBER will dominate all means of transportation and its ease of use will propel it to a mega cap in the coming decade. Our inclusion of MSFT is based on its leadership in cloud computing, a rapidly growing industry. We expect the connectivity and mobile computing demands of Millennials will accelerate. The last stock we are adding to our basket is also the only financial services equity. Though avid consumers, Millennials have shown an aversion to cash, preferring card payment systems, including both debit and credit-based. Accordingly, we are adding the leader in both of these, V, to our Millennials basket (Chart 11). Chart 11Buy BCA’s Millennial Equity Basket Buy BCA’s Millennial Equity Basket Buy BCA’s Millennial Equity Basket Investors seeking long term exposure to stocks lifted by the supremacy of the Millennial generation should own our Millennial basket (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). We would not hesitate to add other sharing economy stocks, including Airbnb, to this basket should they become investable in the near future. Theme #5: ESG Becomes Mainstream Investors are increasingly looking at allocating assets based on environmental, social, and governance (ESG) considerations, and this mini-theme has the potential to become a big trend in the 2020s. There are a number of factors that underpin ESG investing. First, Millennials are climate conscious and given that they already are the largest cohort in the US they will not only dominate spending, but also influence election results. Moreover, via social media Millennials can sway public opinion and participate in the ESG conversation. Second, ECB President Christine Lagarde recent speech to the Economic and Monetary Affairs Committee of the European Parliament is a must read.1 If the ECB were to explicitly focus on climate change policy as part of its monetary policy operations then this is a game changer. Green investment financing including “green bonds” could become mainstream. Keep in mind the as reported in the FT “the European Parliament has declared a climate emergency; the new European Commission (EC) has taken office on a promise of an imminent “green new deal”, and Commission president Ursula von der Leyen has vowed to accelerate emissions cuts.” Last Wednesday, the EC released “The European Green Deal” with a pretty aggressive time table. The EC president said “The green deal is Europe’s man on the moon moment” and presented 50 policies slated to get rolled by 2022 to meet revamped climate goals. The implication is that once ESG takes center stage at a number of these institutions it will be easier to become mainstream and propagate the world over. Third, large institutional investors are starting to adopt an ESG mindset, especially pension plans. These investors with trillions of dollars at their disposal can not only disfavor fossil fuel investment, but also undertake investments in “green projects” via private and public equity markets. Banks are also moving in the “greening of finance” direction and given that they are the pipelines of the global plumbing system, swift adoption will go a long way in taking ESG mainstream. Finally, the electric vehicle (EV) proliferation is another key driver on how the ESG theme will play out in the 2020s. As a reminder, in the US 50% of all energy consumption is gasoline related linked to automobiles. While battery technology still has limitations, EV is no longer a fad as the German and Japanese automakers are starting to make inroads on TSLA. These car manufacturers do not want to be left out, especially if this shift toward EV becomes mainstream in the 2020s. The Chinese are not far behind on the EV manufacturing front, however government policy can really become a game changer. If a number of countries and/or California mandate a large share of all new vehicles sold be EV, then the investment implications will be massive. Investment Implication #8: Avoid Fossil Fuels, Gambling, Alcohol And Tobacco… While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. We are believers that ESG criteria will continue to gain in importance in institutional investment management decisions. Accordingly, we would tend to avoid ‘sin stocks’, including gambling, tobacco and alcohol; demand for their services is unlikely to decline but investment weightings should mean that share prices will underperform. Further, we think a clean energy shift will mean energy stocks will likely continue to be long-term underperformers (Chart 12). Chart 12Areas To Avoid As ESG Becomes Mainstream Areas To Avoid As ESG Becomes Mainstream Areas To Avoid As ESG Becomes Mainstream Final Thoughts On The US Dollar In this report, we tried to focus on the upcoming decade’s big themes that we deem will play out, and centered recommendations on US equities/sectors. We do not want to neglect some macroeconomic variables that tend to mean revert over time. Specifically, the US dollar, interest rates and most importantly US indebtedness, will also be key drivers of investment theses in the 2020s. Currently, debt is rising faster than nominal GDP growth with the government and non-financial business debt-to-GDP profiles on an unsustainable path (second panel, Chart 13). Granted, the saving grace has been generationally low interest rates as the debt service ratios have fallen (top panel, Chart 13). However, if the four decade bull market in Treasury bonds is over, or may end definitively with the next US recession sometime in the early 2020s, then rising interest rates are the only mechanism to concentrate CEOs’ and politicians’ minds. On the dollar front, Chart 14 highlights the ebbs and flows of the trade-weighted US dollar since it floated in the early-1970s. The DXY index has moved in six-to-ten year bull and bear markets. The most recent trough was during the depths of the Great Recession, while the (tentative?) peak was in late-2016. If history repeats, eventually the dollar will mean revert lower in the 2020s, especially given the fiscal profligacy of the current administration that may continue into 2024, assuming President Trump gets re-elected next November. Chart 13Unsustainable Debt Profiles Unsustainable Debt Profiles Unsustainable Debt Profiles Chart 14Greenback’s Historical Ebbs And Flows Greenback’s Historical Ebbs And Flows Greenback’s Historical Ebbs And Flows The US dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the US Congressional Budget Office (CBO) estimates that the US budget deficit will swell to 4.8% of GDP. Assuming the current account deficit widens a bit then stabilizes (usually happens when global growth improves), this will pin the twin deficits at 8% of GDP. This assumes no recession, which would have the potential to swell the deficit even further. The US saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the US trade deficit. Shale productivity remains robust and US output will continue to rise, but the low-hanging fruit has already been plucked.   Another dollar-negative force is its expensiveness. By rising 35% since its trough, the USD has sapped the competitiveness of the US manufacturing sector, which is accentuating the American trade deficit outside of the commodity sector (Chart 14). If the ESG trend ends up hurting oil prices, the US current account will follow the widening deficit in manufactured products. Moreover, the US is lagging Europe on the green revolution. Either the US will have to import green technologies, or the US government will have to provide more subsidies to the private sector. Either way, both of these dynamics will hurt the US current account deficit further. Historically, the currency market is the main vehicle to correct such imbalances. Chart 15Twin Deficits Will Weigh On The US Dollar Twin Deficits Will Weigh On The US Dollar Twin Deficits Will Weigh On The US Dollar The apex of globalization will also hurt the greenback. In a world where all the markets are integrated, borrowers in EM nations often use the reserve currency to issue liabilities at a lower cost. This boosts the demand by EM central banks for US dollar reserves to protect domestic banking systems funded in USD. Moreover, some countries like China implement pegs (both official and unofficial) to the US dollar in order to maintain their competitiveness and export their production surpluses to the US. To do so they buy US assets. If the global economy becomes more fragmented and the Sino-US relationship continues to deteriorate structurally as we expect, then these sources of demand for the dollar will recede. Overlay the widening US current account deficit, and you have the perfect recipe for a depreciating trade-weighted US dollar. Finally, the US is likely to experience more inflation than the rest of the world following the next recession. The US economy has a smaller capital stock as a share of GDP than Europe or Japan, and American demographics are much more robust. This means that the neutral rate of interest is higher in the US than in other advanced economies. As a result, the Fed will have an easier time generating inflation by cutting real rates than both the ECB and the BoJ. Higher inflation will ultimately erode the purchasing power of the dollar and prove to be a structurally negative force for the USD.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Marko Papic Chief Strategist, Clocktower Group marko@clocktowergroup.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Mathieu Savary The Bank Credit Analyst mathieu@bcaresearch.com   References Please click on the links below to view reports: Peak Margins - October 7, 2019 The Polybius Solution - July 5, 2019 War! What Is It Good For? Global Defense Stocks! - October 31, 2018 The Dollar: Will The U.S. Invoke A "Nuclear" Option? - August 30, 2018 Is The Stock Rally Long In The FAANG? - August 1, 2018 Millennials Are Not Coming Of Age; They Are Already Here - June 11, 2018 Brothers In Arms - October 31, 2016 The End Of The Anglo-Saxon Economy?  - April 13, 2016 Apex of Globalization  - November 12, 2014 Footnotes 1           https://www.imf.org/en/News/Articles/2019/09/04/sp090419-Opening-Statement-by-Christine-Lagarde-to-ECON-Committee-of-European-Parliament