Technology Sector Overweighted in Portfolios

With two out of ten portfolio positions invested in technology stocks, it felt like the portfolio had a large commitment to investment already. In fact, given that our primary benchmark (the S&P 500 Index) has a 24 percent weighting in tech, the positions in hardware and software have been important, but not quite enough. In early February, the portfolio model added a communications equipment fund to the model and reduced its commitment to international stocks, which have begun to lag the U.S. market.

It’s been a surprise to us that international has weakened. Maybe it shouldn’t be. China, South Korea and Thailand are moving into the latter stages of their economic recoveries and have all experienced multiple rate hikes by their central banking authorities. India, Brazil and Taiwan saw rates hiked in 2010, and South Korea, Brazil and India saw rates moved higher in 2011. Whether the knee jerk sell-off in their markets is warranted is questionable. China is trying to slow growth from a too robust 10% growth in GDP to a more reasonable, but still fast growing, future growth rate. Still, large economies are difficult to manage. The Asian market weakness seems to be arguing that there is risk of a slowdown overseas.

In any case, while foreign markets have lagged, the additional liquidity provided by the latest Federal Reserve moves to stimulate the economy through QE-II (the second round of quantitative easing) seemed to light a fire under the U.S. market. Since the move was announced in August, and detailed in November, the U.S. market has moved markedly higher. Investments overseas, and in asset classes like junk bonds, have not been able to keep up with the appreciation in domestic stocks. In recent months, we have eliminated the high yield bond funds from the model portfolio and have begun trimming international by selling the Latin America fund.

BCA Research has a technology industry indicator that is making new highs based on solid new orders and pricing power trends in the sector. They point out that return on equity in the sector is also hitting new highs. Cash rich corporate customers have systematically underinvested in technology spending since the bubble. In fact, capital spending on communications equipment is at a multi-decade low.

While telecommunications companies duke it out with cable companies for a declining share of consumer spending, the communications equipment companies are the arms dealers in the battle for market share. While this “buy the arms dealer” strategy failed to work during the tech bubble, it failed then because investors ignored valuations in their stock selection. Today, the industry is very reasonably priced and the positive industry fundamentals signal continued growth in earnings power in the months to come.
 
As long as inventories remain under control, as they are currently, the technology sector appears to be one of the primary engines for appreciation in the U.S. stock market. With reasonable valuations and strong cyclical earnings growth, this latest move positions the portfolio for a continuation of the rally in U.S. stocks.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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