Swimming Naked?

It’s that time of year when investors descend on Nebraska to honor the “Sage of Omaha” and display a reverence usually reserved for religious figures or the Green Bay Packers, but the timing of Berkshire Hathaway’s annual meeting amidst the worst earnings season since 2009 is pure gold both to Buffet devotees and writers.  Buffet has a lot of traits that “modern” money managers despise like avoiding tech stocks and hoarding cash not mention his penchant for pithy quotes. While it may not apply to them, we think ETF investors can learn a lot from this old gem, “Only when the tide goes out do you discover who's been swimming naked.” The fallout from Apple’s big miss continues to rattle tech funds, especially those with market-cap weighted allocations and while you will find just one of those on our weekly list of biggest quant movers, Apple and its outsized impact on the sector means that it could be a long-time before tech stocks find their mojo help to push the markets higher.

Has anyone has ever backtested an indicator that measures market sentiment by the number of articles calling for Warren Buffet to “enhance” shareholder value through dividends and buybacks?  Not that it really matters as the debacle surrounding Apple’s latest earnings release makes it very clear, it’ll be Buffet who ultimately winds up having the last laugh.  Apple has had a volatile run since the company announced it was resuming its dividends and starting a new buyback policy way back in March of 2012.  Since April 1^st of that year, it’s up a mere 18% compared to a 47% return for the S&P 500 and a nearly 80% return for Berkshire Hathaway.  Obviously, we cherry-picked that example and growth investors will line-up to point out that Apple’s stock is up an astounding 9,787% since January 1^st, 2003 while Berkshire is up a mere 200% but that extreme performance which coincides with the inception of many of today’s most popular technology ETFs is weighing heavily on their performance in 2016.

The simple reason why is that most technology funds employ the same market capitalization-weighted systems which have been the mainstay of broader equity indices for decades but when used with a relatively more limited universe of stocks to choose (at least compared to a broader market like the S&P 500) allows a strong long-term outperformer to drastically outweigh the rest of a broader portfolio. At the end of Q1 2015, Apple had a market cap of over $724 billion, around 4% of the S&P 500 and more than Exxon and Berkshire put together!  Only a handful of companies have ever been large enough to make up 4% of the market and their subsequent performance tends to be fairly depressing but tf course no one really cared that such a “sure thing” was now such a significant part of the S&P 500 that analyst’s had to present earnings growth figures both normally and “ex-Apple!” But some investors were paying attention and remembered that it’s impossible to post double digit growth figures for infinity as the stock only managed to tread water after its February 2015 peak and is now down over 26% compared to a 2% loss for the S&P 500 and a 16.8% gain for the #2 holding in most tech funds, Microsoft.

Even after that mighty sell-off Apple is still the largest single position in the Technology Sector Select Fund (XLK) with an allocation of 12.92% while the iShares Technology Sector Fund (IYW) has a 15.99% position and the Vanguard Information Technology Fund (VGT) has nearly 14% in Apple.  In fact, as a sign of how far the stock has fallen, way back in February of 2012 XLK had a 16% allocation to Apple while IYW was over 18% while it still makes up just under 3% of the S&P 500 to retain the largest single allocation although another few weeks of this and Exxon might take back its title.  Not surprisingly, charts of tech sector outperformance relative to the broader market depend heavily on whether or not Apple was advancing until late 2015 when strong showings by Microsoft and other names helped reduce Apple’s weighting in most funds.

So now that the tide, which in this example is Apple if that still isn’t apparent, has receded, we have the chance to pick through the debris left behind to find out which tech funds are still in favor and the short answer is “not many.”  The party is definitely over at least from the perspective of fund flows where most of the larger funds have seen a substantial drop in new assets with the exception of XLK with a $475 million inflow over the last month although we should also note a substantial increase in its short interest ratio as its more than 20% allocation to Apple and Google left long investors primed for disappointment.  But even a rising short interest ratio wasn’t enough to stem the tide of weakening momentum that has pushed XLK’s behavioral score from over 70 on April 7^th to just under 50 last Friday although XLK has a long way to go before hitting rock bottom.  That spot is reserved for VGT whose overall ETFG behavioral score has collapsed over 48% last week which brought the fund into a hypothetical list of 100 LOWEST ranked behavioral funds, something almost inconceivable for an over $8 billion fund.

But the real genius of Buffet’s quotes is their ability to capture timeless truths and there’s nothing as timeless as playing a game of “chase the leaders” as investors rush to move their capital out of Apple to someone who can justify their earnings multiples, like Facebook and Amazon.  Amazon is typically not included in tech funds with one notable exception, the First Trust Dow Jones Internet Index Fund (FDN) which not only has more than 10% in both stocks but also underweights Google relative to other tech funds and has no Apple exposure of any kind.  The net result was the fund managed to close in the green last week with a .14% return while simultaneously being the only tech fund to make our ETFG Behavioral Top 100 list.  Buyers should be aware that FDN is even more concentrated than XLK or IYW with just 42 positions versus 74 for XLK and 140 for IYW.

Finally, investors need to ask themselves where does Apple go from here?  While earnings and revenue disappointed, Apple has pulled back to support at $93 and now sports a P/E multiple below ten while FB’s is over 91 and Amazon’s is still a mind boggling 531.  Then again, investors aren’t likely to be in a forgiving mood after such a strong advance over the last decade and thanks to those market-cap weighting systems, most tech funds are like in for a lot more pain before this is over.

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