Technology

Highlights Portfolio Strategy The risk/reward tradeoff remains squarely to the downside and we are turning cyclically (3-12 month horizon) cautious on the prospects of the broad equity market. The Presidential cycle, UBER’s IPO, the SPX hitting all-time highs following the initial December 2018 yield curve inversion, and two additional yield curve inversions signal that this time is no different and a recession is likely upon us in the coming 18 months. The re-escalation of the U.S./China trade tussle along with the risk of an antitrust investigation into Apple, waning capital outlays, softening exports and deteriorating operating conditions warn that it does not pay to be overweight the S&P tech hardware storage & peripherals (THS&P) index. Our tech EPS model is flashing red on the back of sinking capex and an appreciating U.S. dollar, deteriorating operating metrics signal that tech margins are under attack and exports are also in a freefall, suggesting that the time is ripe to put the tech sector on downgrade alert. Recent Changes Downgrade the S&P THS&P index to neutral, today. Put the S&P tech sector on downgrade alert. Table 1 A Recession Thought Experiment A Recession Thought Experiment Feature The SPX appeared to crack early in the week, but dovish Fed President statements saved the day and stocks recovered smartly to end the week on a high note. Our tactically (0-3 month) cautious equity market stance has served us well and has run its course. We are currently leaning toward a cyclically (3-12 month) cautious stance as a slew of our cyclical indicators have rolled over decisively. At the current juncture the big call to make is on the longevity of the business cycle. Crudely put, can the Fed engineer a soft landing or is the looming easing cycle a precursor of recession (Chart 1)? We side with the latter. Chart 1What’s The Opposite Of Bond Vigilantes? What’s The Opposite Of Bond Vigilantes? What’s The Opposite Of Bond Vigilantes? This is U.S. Equity Strategy service’s view. BCA’s house view remains constructive on a cyclical 3-12 month time horizon. As a reminder, the ongoing expansion is officially the longest on record and BCA’s house view also calls for recession in late-2020/early-2021. Stan Druckenmiller once famously said “…you have to visualize the situation 18 months from now, and whatever that is, that's where the price will be, not where it is today." Thus, if BCA’s recession view is accurate then we need to start preparing the portfolio for a recessionary outcome. This week we conduct a simple thought experiment on where and why the SPX will be headed as the economy flirts with recession. But first, we rely on the message from our indicators to guide us in determining if the cycle is nearing an end. Last December parts of the yield curve slope inverted (Chart 2) and our simple insight was that the market almost always peaks following the yield curve inversion and we remained bullish on the prospects of the broad equity market and called for fresh all-time highs based on the results of our research.1 On May 1, 2019 we got confirmation as the SPX vaulted to new all-time highs, so that box is now checked. Chart 2The Yield Curve... The Yield Curve... The Yield Curve... Beyond the traditional yield curve inversion that forecasts that the Fed’s next move will be a cut and eventually the cycle ends, other yield curve type indicators have inverted and also foreshadow the end of the business cycle. Charts 3A & 3B show that the unemployment gap and another labor market yield curve type indicator have both inverted signaling that the business cycle is long in the tooth. Chart 3A...Is Always Right... ...Is Always Right... ...Is Always Right... Chart 3B...In Predicting Fed Cuts ...In Predicting Fed Cuts ...In Predicting Fed Cuts This time is no different and the business cycle will end. Why? Because the Fed has likely raised interest rates (as we first posited on November 19, 2018 and again on December 3, 2018) by enough to trigger a default cycle in the most indebted segment of the U.S. economy where the excesses are most prominent in the current expansion: the non-financial business sector (Chart 4A). Chart 4AMind The Corporate Debt Excesses Mind The Corporate Debt Excesses Mind The Corporate Debt Excesses Chart 4BDefault Cycle Looming Default Cycle Looming Default Cycle Looming Already, junk bond market spreads are widening and the yield curve is predicting that a default cycle is around the corner (yield curve shown on inverted scale, bottom panel, Chart 4B).  Another interesting indicator is the Presidential cycle. Chart 5 updates our work from last year showing years 2 & 3 of 17 Presidential cycles dating back to 1950. In the summer of year 3 the SPX typically peaks. Finally, the anecdote of the biggest unicorn, UBER, ipoing on May 10, 2019 also likely marks the ending of the cycle. Therefore if recession looms in the coming 18 months what is the typical magnitude of the SPX EPS drawdown and what multiple do investors pay for trough earnings? Chart 5Presidential Cycle Says Sell Presidential Cycle Says Sell Presidential Cycle Says Sell While the two most recent recessionary earnings contractions have been severe, we are conservative in estimating a garden variety recession causing a 20% EPS fall. S&P 500 2018 EPS ended near $162/share. This year $167/share is likely and we are now revising down our forecast for next year to $175/share from $181/share previously. A conservative 20% drawdown sets us back to $140/share in 2021. Dating back to the late 1970s when our IBES dataset on the forward P/E multiple commences, the trough forward P/E multiple during recessions averages out to 10x (Chart 6). Remaining on a conservative path we will use 13.5x, or the recent December 2018 trough multiple as our worst case multiple and a sideways move to 16.5x as the most optimistic case. This implies an SPX ending value of between 1890 and 2310 will be reached some time in 2020, with the former resetting the equity market back near the 2016 BREXIT lows. Chart 6Trough Recession Multiple Averages 10x Trough Recession Multiple Averages 10x Trough Recession Multiple Averages 10x As a result, we are not willing to play a 100-200 point advance for a potential 1000 point drawdown, the risk/reward tradeoff is to the downside. Can and has the Fed previously engineered soft landings that have caused big relief rallies in the equity market? Six times since the 1960s: once in each of the mid-1960s, early-1970s, mid-1970s, mid-1980s and mid-1990s and once in 1998 (top panel, Chart 7). Chart 7Six Mid-cycle Easing Attempts Six Mid-cycle Easing Attempts Six Mid-cycle Easing Attempts Three easing cycles were not forecast by a yield curve inversion, but the mid-1960s, the mid-1990s and in 1998 the yield curve cautioned investors that an easing cycle was looming (bottom panel, Chart 7). Specifically in 1998 the Fed only acted after the equity market fell by 20%. Another interesting observation is that ex-post five of these six iterations were truly mid cycle, one was very late cycle, but none took place in year 11 of an expansion as is currently the case. We are in uncharted territory. Chart 8 shows the mean profile of the S&P 500 six months prior to and one year post the initial Fed cut. Our assumption is that a cut in July may materialize, thus the vertical line in Chart 8 denotes t=0, which is in sync with the bond market that is pricing a greater than 75% chance of this occurrence. The subsequent market rallies were significant. Our insight from this research is that we already had the explosive rally as Chart 8 depicts, owing to the Fed’s completed pivot, with the stock market rallying from the 2018 Christmas Eve lows to the May 1, 2019 all-time highs by 26%. But, the jury is still out. The biggest risk to our call is indeed a continued rally in the S&P 500 on easy money. A way to mitigate this risk of missing out on a rally is by going long SPX LEAPS Calls once a greater than 10% correction takes root. Chart 8Is The Rally Already Behind Us? Is The Rally Already Behind Us? Is The Rally Already Behind Us? Keep in mind, that for the Fed to act and cut rates, stocks will likely have to breach the 2650 level, a point where a reflexive fall will further shake investor’s confidence in profit growth. In other words, the bond market is screaming that Fed cuts are looming, but it also means that stocks have ample room to fall before the Fed cuts rates, i.e. a riot point will force the Fed’s hand. Another big risk to this call is a swift positive resolution on the U.S./China trade dispute, and/or an unprecedented easing from the Chinese authorities which will put us offside as a euphoric rise will definitely ensue. Again SPX LEAPS Calls are an excellent way to position for such an outcome. Netting it all out, the risk/reward tradeoff remains squarely to the downside and we are turning cyclically (3-12 month horizon) cautious on the prospects of the broad equity market. The Presidential cycle, UBER’s IPO, the SPX hitting all-time highs following the initial December 2018 yield curve inversion, and two additional yield curve inversions signal that this time is no different and a recession is likely upon us in the coming 18 months. Thus, this week we are further de-risking the portfolio by downgrading a tech subindex to neutral, setting a tighter stop on a different long term tech subsector holding that has been the cornerstone of the equity bull market, and putting the overall tech sector on downgrade watch. Downgrade Tech Hardware Storage & Peripherals To Neutral In the context of further de-risking the portfolio we are downgrading the S&P tech hardware storage & peripherals index to a benchmark allocation and booking a small loss of 1.0% in relative terms since inception. Four reasons underpin our downgrade of this index that comprises almost 1/5 of the S&P tech market cap. First, index heavyweight Apple has 20% foreign sales exposure to the Greater China region. While we doubt the Chinese will directly retaliate to the U.S. restriction on Huawei by directly targeting Apple, it is still a risk. Moreover, recent news of the FTC and the DOJ targeting GOOGL and FB pose a risk to Apple, especially given its App Store dominance. Any negative news on either front would take a bite out of the sector’s profits. Second, capex has taken a bit hit. Chart 9 shows industry investment is almost nil and capex intentions from regional Fed surveys and from CEO confidence surveys signal more pain down the line. Third, the S&P THS&P index’s internationally sourced revenues are near the 60% mark, and computer exports are also flirting with the zero line. Worryingly, deflating EM Asian currencies are sapping consumer purchasing power and are weighing on industry exports (third panel, Chart 10). Chart 9Capex Blues Capex Blues Capex Blues Chart 10Exports... Exports... Exports... Similarly, global trade volumes have sunk into contractionary territory and to a level last seen during the Great Recession (not shown). With regard to export expectations the recently updated IFO World Economic Survey still points toward sustained global export ails (second panel, Chart 10). More specifically, tech laden Korean and Taiwanese exports are outright contracting at an accelerating pace and so are Chinese exports. Tack on the negative signal from the respective EM Asian stock market indices and the implication is that more profit pain looms for the S&P THS&P index (Chart 11). Finally, on the domestic front, new orders-to-inventories (NOI) have not only ground to a halt from the overall manufacturing sector, but also computer and electronic product NOI are not contracting on a short-term rate of change basis (bottom panel, Chart 10). Tracking domestic consumer outlays on computer and peripheral equipment reveals that they too have steeply decelerated from the cyclical peak reached in early 2018, painting a softening picture for industry sales growth prospects (Chart 12). Chart 11...Under Pressure ...Under Pressure ...Under Pressure Chart 12Soft Sales Backdrop Soft Sales Backdrop Soft Sales Backdrop  The re-escalation of the U.S./China trade tussle along with the risk of an antitrust investigation into Apple, waning capital outlays, softening exports and deteriorating operating conditions warn that it does not pay to be overweight the S&P THS&P index. Nevertheless, before getting too bearish there is a silver lining. This index has a net debt/EBITDA of 0.5x versus the non-financial broad market of 2x. On the valuation front this tech subindex trades at 28% discount to the non-financial broad market on an EV/EBITDA basis suggesting that most of bad news is already reflected in bombed out valuations (Chart 13). The re-escalation of the U.S./China trade tussle along with the risk of an antitrust investigation into Apple, waning capital outlays, softening exports and deteriorating operating conditions warn that it does not pay to be overweight the S&P THS&P index. Bottom Line: Downgrade the S&P THS&P index to neutral for a modest relative loss of 1.0% since inception. The ticker symbols for the stocks in this index are: BLBG: S5CMPE – AAPL, HPQ, HPE, NTAP, STX, WDC, XRX. Chart 13But B/S Remains Pristine But B/S Remains Pristine But B/S Remains Pristine Put Tech On Downgrade Alert We are compelled to put the S&P tech sector on our downgrade watch list as President Trump’s hawkish trade talk and actions since May 5 warn that tech revenues (60% export exposure) and profits will likely remain under intense downward pressure. The way we will execute this tech sector downgrade to underweight will be via the S&P software index, the sector’s largest market cap weight. A downgrade to neutral in the S&P software index would push our S&P tech sector weight to a below benchmark allocation. Thus, we are initiating a stop near the 10% relative return mark on the S&P software high-conviction overweight call since the December 3, 2018 inception and also lift the stop to 27% from 17% relative return on the cyclical overweight we have on the S&P software index since the November 27, 2017 inception. Any near term stock market pullback will likely trigger these stops and push the tech sector to an underweight position. Stay tuned. With regard to the overall tech sector, our EPS model is on the verge of contraction on the back of sinking capex and a firming U.S. dollar (middle panel, Chart 14). In more detail, tech capex has recaptured market share swinging from below 6% to above 13% in the past decade and now has likely hit a wall similar to the late 1990s peak (second panel, Chart 15). On a rate of change basis tech capital outlays have all peaked and national data corroborate the message from stock market reported data (bottom panel, Chart 15). Chart 14Grim EPS Model Signal Grim EPS Model Signal Grim EPS Model Signal Chart 15Exhausted Capex? Exhausted Capex? Exhausted Capex? The San Francisco Fed’s Tech Pulse Index (comprising coincident indicators of activity in the U.S. information technology sector) is also closing in on the expansion/contraction line warning that tech stocks are in for a rough ride (bottom panel, Chart 14). Delving deeper into operating metrics, we encounter some profit margin trouble for tech stocks. Not only do industry selling prices continue to deflate, but also our tech sector wage bill gauge is picking up steam. Taken together, all-time high profit margins – double the broad market – appear unsustainable and something has to give (Chart 16). On the export relief valve front, the sector faces twin headwinds. First the trade war re-escalation suggests that an interruption/disruption of tech supply chains is a rising risk, and the firming greenback will continue to weigh on P&Ls as negative translation effects will hit Q2, Q3 and likely Q4 profits (Chart 17). Chart 16Margin Trouble Margin Trouble Margin Trouble Chart 17Rising Dollar Will Weigh On Revenues & Profits Rising Dollar Will Weigh On Revenues & Profits Rising Dollar Will Weigh On Revenues & Profits Netting it all out, our tech EPS model is flashing red on the back of sinking capex and an appreciating U.S. dollar, deteriorating operating metrics signal that tech margins are under attack and exports are also in a freefall, suggesting that the time is ripe to put the tech sector on downgrade alert. Nevertheless, there are two sizable offsets contrasting all the grim news. Tech stocks are effectively debt free with the net debt/EBITDA sitting on the zero line and valuations a far cry from the tech bubble era. Finally, the drop in interest rates via the 10-year yield and looming Fed cuts will underpin these growth stocks that thrive in a disinflationary backdrop (Chart 18). Netting it all out, our tech EPS model is flashing red on the back of sinking capex and an appreciating U.S. dollar, deteriorating operating metrics signal that tech margins are under attack and exports are also in a freefall, suggesting that the time is ripe to put the tech sector on downgrade alert. Bottom Line: We are compelled to put the tech sector on our downgrade watch list. We will execute the S&P tech sector downgrade to underweight when the S&P software index’s stops are triggered. This would push the S&P software index to neutral from currently overweight. Stay tuned. Chart 18But There Is An Offset: Melting Yields Help Growth Stocks But There Is An Offset: Melting Yields Help Growth Stocks But There Is An Offset: Melting Yields Help Growth Stocks   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Underweight High-Conviction Shy Away From Near-Monopolies Shy Away From Near-Monopolies Late Friday night news broke that the DOJ was working on an antitrust investigation into Alphabet Inc., parent of GOOGL/GOOG, and on Monday, according to the Wall Street Journal, the “FTC got jurisdiction for a possible Facebook Inc. antitrust investigation”. We first co-authored a Special Report with our sister Geopolitical Strategy Service last August titled “Is The Stock Rally Long In The FAANG?” and warned investors that it was a matter of when, not if, that the U.S. government would clamp down on these monopolies that enjoy record profits and never seen before profit margins (panels 3 and 5). Then in early December, we cautioned investors to specifically avoid the S&P interactive media & services index (dominated by GOOGL & FB) as our conclusion was that both antitrust (particularly in the case of Alphabet Inc.) and privacy regulation (particularly in the case of Facebook Inc.) added significant risk to these near monopolies at a time when calls for legislating both had dramatically amplified. Bottom Line: Looming privacy regulation and news of an antitrust investigation into Alphabet Inc. underscore that more pain lies ahead for the S&P interactive media & services index. We reiterate our high-conviction underweight. The ticker symbols of the stocks in this index are: S5INMS – GOOGL, GOOG, FB, TWTR and TRIP.        

Off To The Races Off To The Races ​​​​​​​In our recent Weekly Report, we initiated a pair trade, going long S&P managed health care/short S&P semiconductors. Given the trade’s extreme volatility, we initiated this trade with a stop loss at the -7% mark. However, this market-neutral trade has outperformed beyond our expectations, currently up 14% since its inception at the beginning of last week. Accordingly, and in order to protect these outsized gains, we are moving the goalposts and taking the stop to the 10% mark. From a macro perspective, nothing has changed to shake our conviction. Job openings, the ultimate driver of managed health care enrollments, are upbeat compared with declining global semi revenues (second panel). Further, on the relative pricing power gauge front, overall wage inflation is continuing to outpace DRAM prices (bottom panel). The combination implies more gains in store for the pair trade, despite our risk management change. Bottom Line: We reiterate our long S&P managed health care/short S&P semis pair trade and change our -7% stop loss recommendation to a 10% stop. The ticker symbols for the stocks in the S&P managed health care and S&P semi indexes are: BLBG: S5MANH – UNH, ANTM, HUM, CNC, WCG and BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO, respectively.

A High-Octane Pair Trade Idea A High-Octane Pair Trade Idea While health care and tech stocks started the year on a similar footing, a wide gulf has opened that is likely to, at least partially, reverse in the back half of the year. This dichotomy is most evident at the subsector level where managed health care stocks are still down in absolute terms for the year, whereas chip stocks are up roughly 20% year-to-date. This is an exploitable gap and on Monday, we suggested a new pair trade: long S&P managed health care/short S&P semiconductors. With regard to relative macro drivers, managed health care has the upper hand. The chart at the side shows that relative demand dynamics clearly favor HMOs and are working against chip stocks. Non-farm payroll growth is trouncing global semi billings (second panel). The message from the small business sector is similar with the labor market upbeat compared with declining global semi revenues (third panel). Finally, on the relative pricing power gauge front, overall wage inflation is outpacing DRAM prices (bottom panel). Bottom Line: We initiated a long S&P managed health care/short S&P semis pair trade on Monday with a stop loss at the -7% mark; please see Monday’s Weekly Report for more details. The ticker symbols for the stocks in the S&P managed health care and S&P semi indexes are: BLBG: S5MANH – UNH, ANTM, HUM, CNC, WCG and BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO, respectively.

Highlights Portfolio Strategy Firming relative demand and input cost dynamics, the Medicare For All (MFA)-induced panic selling in HMOs coupled with 5G euphoria buying in semis have set the stage for an exploitable pair trade opportunity: long S&P managed health care/short S&P semiconductors. Relative supply/demand dynamics, crumbling lumber prices, lower interest rates and compelling valuations and technicals all suggest that the long homebuilding/short home improvement retail pair trade is in the early innings. Recent Changes Initiate a long S&P managed health care/short S&P semiconductors trade today, with a tight stop loss at -7%. Table 1 On Edge On Edge Feature Equities hit a speed bump last week, as President Trump’s trade related tweets instilled some fear back into the markets. Investor complacency reigned supreme and, given the liquidity crunch, risk premia exploded higher with the VIX more than doubling from the recent lows. Historically, a parabolic rise in policy uncertainty is synonymous with an equity market selloff and a widening in risk premia; last week was no different (economic policy uncertainty shown inverted, second panel, Chart 1). Adding insult to injury, given that the forward P/E multiple expansion explained all of the equity market’s advance year-to-date as we highlighted three weeks ago, the trade-related melt up in policy uncertainty caused a mini meltdown in the forward multiple as financial conditions tightened (financial conditions shown inverted, third panel, Chart 1). The implication is that short-term equity market caution is still warranted as we have been writing over the past few weeks, at least until the U.S./China trade dispute dust settles. Chart 1Caution Still Warranted Caution Still Warranted Caution Still Warranted Chart 2Tenuous Trio Tenuous Trio Tenuous Trio The recent simultaneous rise of three asset classes, that we call “the tenuous trio”, warned that something had to give: stocks, bond prices and the trade-weighted U.S. dollar cannot all go up in tandem for an extended period of time. When this happens it is typically a forewarning of an equity market snap (Chart 2). One simple explanation is that a rising greenback comes back and haunts equities via a negative P&L hit, albeit with a lagged effect. Irrespective of where the U.S. dollar will move in the coming months, it will continue to weigh on EPS as the surge in the greenback took root from April to November last year. Thus, with a six-to-nine month lag it will continue to infiltrate EPS and Q2 – which the sell-side already expects to barely breach year ago levels – will also feel the U.S. dollar’s wrath. Were the dollar to continue its ascent from current levels, it would put in jeopardy the back half of this year’s EPS growth numbers, especially Q4/2019 that sell-side analysts forecast to jump to 8%, according to I/B/E/S data. This week we recommend putting on a new pair trade involving an unloved health care subgroup and a mighty tech sector subindex but with a tight stop, and also update an intra-consumer discretionary market-neutral housing-levered pair trade. Importantly, the 12-month forward EPS number is artificially rising. Chart 3 shows that calendar 2019 and 2020 EPS estimates continue to build a base, but the 12-month forward number has been rising since early-February. What explains the increase in the 12-month forward estimate is arithmetic. In other words, despite a multi-month downgrading of calendar 2019 and 2020 EPS, the first two quarters of next year are forecast to come in significantly higher than 2019’s first six months. As the latter roll off and the former get added to the 12-month forward EPS number, a deceiving jump occurs. For next year, we continue to expect $181 EPS, and we would lean against the double-digit EPS growth in 2020 that the sell-side currently forecasts. Our top down macro S&P 500 EPS model softened anew recently, warning that mid-single digit growth, at best, is more likely than low double-digit growth (Chart 4).   Chart 3Artificial EPS Rise Artificial EPS Rise Artificial EPS Rise Chart 4SPX Macro EPS Model Forecasts Softness SPX Macro EPS Model Forecasts Softness SPX Macro EPS Model Forecasts Softness Finally, one of the tech sector’s invincible subgroups is cracking with the S&P semis relative performance hitting a wall both versus the broad market ex-TMT and versus the NASDAQ 100. This is significant not only from a sentiment perspective, but also because semis have high international sales exposure in general and China in particular (Chart 5). Chart 5Vertigo Warning Vertigo Warning Vertigo Warning This week we recommend putting on a new pair trade involving an unloved health care subgroup and a mighty tech sector subindex but with a tight stop, and also update an intra-consumer discretionary market-neutral housing-levered pair trade. New High-Octane Pair Trade Idea While health care and tech stocks started the year on a similar footing, a wide gulf has opened that is likely to, at least partially, reverse in the back half of the year. This dichotomy is most evident at the subsector level where managed health care stocks are still down in absolute terms for the year, whereas chip stocks are up roughly 20% year-to-date (Chart 6). This is an exploitable gap and today we suggest a new pair trade: long S&P managed health care/short S&P semiconductors. Chart 6Exploitable Reversal Looms Exploitable Reversal Looms Exploitable Reversal Looms Bernie Sanders’ revamped MFA bill sent the managed health care group to the ER. While there is heightened uncertainty surrounding MFA and we are working on a joint Special Report with our sister Geopolitical Strategy service due on June 3rd, this is likely a 2022 story. Not only will Sanders have to win the Democratic candidacy and subsequently the Presidential election, but also the GOP would have to lose the Senate. This is an extremely low probability event that has dealt a massive blow to HMO stocks. On the flip side, semis are priced for perfection. The recent catalyst for this group’s stratospheric rise was Apple’s patent settlement with Qualcomm that set in motion a 5G-related euphoria. Again 5G is a late-2021 story and a lot of good news is already priced in to semis stocks. Moreover, historically, semi cycles last four-to-five quarters and investors’ neglect of the semi downcycle is puzzling as we have recently concluded just two down quarters. Explicitly, what is truly baffling is that 12-month forward EPS are slated to contract in absolute terms and forward sales are hovering near the zero line, yet the Philly SOX index recently vaulted to all-time highs. Taken together, we would lean toward health care insurers at the expense of semiconductor stocks. Netting it all out, relative demand and input cost dynamics, the MFA-induced panic selling in HMOs coupled with 5G euphoria buying in semis have set the stage for an exploitable pair trade opportunity: long S&P managed health care/short S&P semiconductors. With regard to relative macro drivers, managed health care has the upper hand. Chart 7 shows that relative demand dynamics clearly favor HMOs and are working against chip stocks. Non-farm payroll growth is trouncing global semi billings. The message from the small business sector is similar with the labor market upbeat compared with declining global semi revenues. Finally, on the relative pricing power gauge front, overall wage inflation is outpacing DRAM prices. On all three fronts, the message is to expect a mean reversion higher in the relative share price ratio. Chart 7Buy Managed Health Care… Buy Managed Health Care… Buy Managed Health Care… Chart 8…At The Expense… …At The Expense… …At The Expense… Input cost/inventory dynamics suggest that HMOs also have the advantage. The health care insurance employment cost index is growing on a par with inflation, but semi industry employment is climbing at a rate over 5%/annum (bottom panel, Chart 8). Taking stock of medical cost inflation, costs are still melting, however global semi inventories are expanding. The upshot is that relative share prices have ample upside (middle panel, Chart 8). Finally, the previous relative valuation overshoot has returned to the neutral zone and, encouragingly, relative technicals are probing multi-year lows near one standard deviation below the historical mean. Importantly, over the past two decades every time our Technical Indicator has hit such a depressed level, a playable rebound in relative share prices has ensued (bottom panel, Chart 9). Chart 9…Of… …Of… …Of… Chart 10…Semis …Semis …Semis Nevertheless, this highly volatile market-neutral trade faces one big risk we previously alluded to: relative profit expectations are extended. In other words, the bombed out S&P semiconductor forward EPS and revenue projections are masking the relative profit and revenue backdrop (Chart 10). Netting it all out, relative demand and input cost dynamics, the MFA-induced panic selling in HMOs coupled with 5G euphoria buying in semis have set the stage for an exploitable pair trade opportunity: long S&P managed health care/short S&P semiconductors. Bottom Line: Initiate a long S&P managed health care/short S&P semis pair trade today with a stop loss at the -7% mark. The ticker symbols for the stocks in the S&P managed health care and S&P semi indexes are: BLBG: S5MANH – UNH, ANTM, HUM, CNC, WCG and BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO, respectively. Homebuilding/Home Improvement Retail Pair Trade Update In late-January we put on a market, sector and subindustry neutral trade preferring homebuilders to home improvement retailers (HIR) as a way to benefit from the increase in residential construction at the expense of residential investment. This trade moved in the black from the get-go and is now generating alpha to the tune of 7% since inception, but more gains are in store in the coming months. President Trump’s hawkish tariff rhetoric should keep interest rates at bay, at least for a short while, and bond market nervousness is more of a boon to homebuilders than to HIR (top panel, Chart 11). The drop in the price of mortgage credit along with minor price concessions from homebuilders are causing sales of new homes to take off versus existing home sales (middle panel, Chart 11). Granted, bankers remain willing extenders of residential loans and the latest Fed Senior Loan Officer Opinion Survey revealed that demand for residential credit is making a comeback following a near yearlong decline (not shown). As a result, relative loan growth metrics also underpin the relative share price ratio (bottom panel, Chart 11). Chart 11Still In Early Innings Still In Early Innings Still In Early Innings In sum, relative supply/demand dynamics, crumbling lumber prices, lower interest rates and compelling valuations and technicals all suggest that the long homebuilding/short HIR pair trade is in its early innings. Importantly, the new/existing home sales–to-inventory ratio is an excellent leading indicator of relative share prices and is currently emitting an unambiguously bullish signal for homebuilders at the expense of HIR (Chart 12). Chart 12Supply/Demand Backdrop Says Stick With This Pair Trade Supply/Demand Backdrop Says Stick With This Pair Trade Supply/Demand Backdrop Says Stick With This Pair Trade Chart 13Relative Sales ##br##Expectations… Relative Sales Expectations… Relative Sales Expectations… Examining the relative demand backdrop reveals that homebuilders will continue to outshine HIR. Current readings in the NAHB home sales survey versus the remodeling survey and future expectations both point to more gains in the relative share price ratio (Chart 13). The felling in lumber prices also represents a benefit to homebuilders to the detriment of HIR. Lumber is a key building input cost in new home construction so any price liquidation is a boon for homebuilding margins. In contrast, HIR makes a set margin on lumber sales, therefore deflating lumber prices cut HIR profits (Chart 14). Chart 14…Felling Lumber Prices And … …Felling Lumber Prices And … …Felling Lumber Prices And … Chart 15…Bombed Out Valuations Signal More Relative Share Price Gains …Bombed Out Valuations Signal More Relative Share Price Gains …Bombed Out Valuations Signal More Relative Share Price Gains Finally, on the relative valuation and technical fronts, there is anything but froth. In fact, the relative price to book ratio is perched near an all-time low and relative momentum has only recently troughed and has yet to reach the neutral zone (Chart 15). In sum, relative supply/demand dynamics, crumbling lumber prices, lower interest rates and compelling valuations and technicals all suggest that the long homebuilding/short HIR pair trade is in its early innings.       Bottom Line: Stick with a long S&P homebuilders/short S&P HIR pair trade. The ticker symbols for the stocks in the S&P homebuilding and S&P HIR indexes are: BLBG: S5HOME – PHM, DHI, LEN and BLBG: S5HOMI – HD, LOW, respectively.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps