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One Easy Way To Beat The Market: Go Overweight XLK Vs. SPY

A lot of people think beating the market is a very hard thing to do. Indeed, it is, and it takes time and energy. We believe actively allocating at the sector level is a good middle-ground that will generate higher alpha with less risk than other strategies. We suggest actively allocating by Global Industry Classification Standard (GICS-1) Sectors within the wider index to try to achieve a superior return. We promote a strategy of going overweight winners and underweight losers. This then gives us a better return than the market. One of the easiest calls we’ve developed is that the digitization of the world has been expedited by the pandemic. We firmly believe for this reason the Technology Select Sector SPDR ETF (NYSEARCA:XLK) will continue to outperform, as it has for years.

Let’s Look At Some Performance Data To Show You What We Mean

So, the market has returned 14% this year. That’s pretty good given the year we’ve had. However, as you can see, when you look at the differences within The GICS-1 Sectors, there is a completely different story that is told. If you were to hold a portfolio of just the S&P’s best- and worst-performing sectors in equal positions, which was Information Technology (XLK) and Energy (XLE), then you would be negative for the year. However, if you owned these in the weighted proportions which make up the S&P 500, you'd be ahead since Information Technology makes up about 24% of the index by market cap, whereas Energy is less than 3%. Of course, if you only owned XLK over the last year and didn’t own any other sectors, then you would have had the highest performance.


1W

1M

6M

YTD

1Y

3Y

5Y

10Y

XLK Total Return

9.67%

5.14%

32.77%

33.98%

45.02%

99.15%

195.94%

469.96%

S&P 500 Total Return

7.36%

4.54%

24.34%

10.33%

16.26%

43.62%

84.88%

252.06%

Is Owning XLK The Same As Owning FAANG Stocks? No.

When you look over a longer time period, the outperformance of XLK is even more impressive. You need to understand before purchasing XLK that owning this ETF is not the same as owning FAANG stocks. While some investors may be dejected about this, we actually think this is a good thing. The top two holdings of XLK are Microsoft and Apple. This is also the top two holdings of the S&P 500 as a whole. So, we think there’s a good upside here. Particularly since recent history, particularly (the last 10 years), the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) and XLK tend to decouple in times of economic expansion, and correlations trace each other closer during bear-markets, like the panicked selling of March 2020.


As you can see from the XLK holdings (below), you have a good mix of established technology companies with consistent earnings (not to mention some great dividend names like Cisco (NASDAQ:CSCO)) and not as much valuation risk as the FAANGs. Still, you also have Apple, which, as we pointed out in a recent article, Apple: The Fairer of The FAANGs, is no slouch when you compare it with the rest of the group. We also like that even though many of these Tech stocks have enjoyed amazing profits, particularly given we have been undergoing the worst economic shock of our lifetimes. We think many of them, like Microsot (NASDAQ:MSFT) and Apple (NASDAQ:AAPL), will be positioned to do very well as economic activity normalizes. While we think some mean reversion may occur regarding relative performance as the re-opening trade accelerates, we think it is early in the process.

XLK Versus SPY: Despite Rotation, XLK Will Continue to Outperform


We think tech's overperformance from the broader market will continue, partially due to other sectors lagging in the coming re-opening environment and partially because many technology names have proven the ability to do well with or without COVID-19. This, to us, amounts to passing the ultimate stress test and justifies the valuation levels we currently have. Some methods by which we analyze the big Tech stocks suggest they may actually be undervalued. When we do the price-to-coupon calculations on some of these big technology names' debt, their P/E ratios don't seem so 90's tech bubble. Not many internet companies were borrowing money at rates only slightly above what the full faith and credit of Uncle Sam gets. These are some of the most successful private entities in creating prosperity in human history.


One thing you’ll notice is that three of the top ten holdings of the S&P 500 are the same. One thing that we like about XLK's top holdings and the over-exposure it provides to names like MasterCard (NYSE:MA), Visa (NYSE:V) Inc., and PayPal (NASDAQ:PYPL) Holdings Inc is not only attractive from the broader secular trends favoring technology, but these names also hold a major cyclical kicker. In other words, you have to make a distinction between the rotation from FAANG names to cyclical and the economic properties of XLK because they are very different.

The closing of the massive performance gap between the two is not going to be as acutely felt because of the diverse make-up of XLK and the inclusion of companies that benefit from massive network effects and will outperform during periods of cyclical economic expansion, let alone the stimulus and other positive catalysts, such as Pfizer's and Moderna's vaccines. There are plenty of cyclical beneficiaries in XLK, do not make the mistake of thinking this ETF will begin to underperform the S&P 500. We will outline a few reasons at the tactical, medium-term, and long-term/secular time horizons why we believe outperformance will continue below.

Tactical Outlook for XLK


With recent vaccine news, many market pundits have theorized that there will be a massive rotation from the FAANG stocks into what we call "Epicenter" stocks, or those most affected by COVID-19. Institutional investors we talk to are still bullish on Tech and FAANG. While many believe this rotation will necessarily mean that the value of tech stocks will decline relative to these others, we do not think this will cause Tech to underperform versus the wider market, even if it lags relatively to ‘epicenter’ for a while, particularly the Technology firms that comprise the XLK. Epicenter's overdue catch-up after-all has more to do with a lack of earnings visibility and these companies' ability to survive and increase operating leverage. The bull-thesis for technology has not changed at all; we believe it is more solid than ever. The bottom line is that we see short-term weaknesses as opportunities to accumulate more shares.

The Relative Strength Index (RSI) shown above for XLK shows that it is not in what is considered overbought territory. It would also make sense, given the relatively recent development of previously considered growth stocks, also obtaining a 'safe-haven' status because of their large size and the consistency of consumer demand for their products and services, that its rate would be elevated. Still, it is not in OB territory yet and is a significant percentage below that level. As you can see, the RSI of XLK rarely has deviated very significantly above or below overbought or oversold conditions.


The above chart shows how we think capital sloshes around between GICS-1 Sectors and various equities groups within the S&P 500 based on how the pandemic is going. The correlations between rising cases and falling stock prices were more close in Waves 1 and 2. However, we have noticed recently it has begun to break down.

Despite this migration, we will elaborate further on how so much cash is still on the sidelines. Many investors have maintained bearish positioning that much of this cash, when it does return, will go into the now undoubtedly robust Technology stocks. Take AAPL, in a quarter where GDP contracted by over 30%; it had double-digit growth in its business's key elements that acted as a countercyclical hedge to declining sales in other areas. All and all that the biggest headwind the world's largest company faced is a few weeks production delay in an incredibly complex supply-chain that is adversely affected by a trade war and global pandemic, which means we don't think an implosion of its P/E ratio is coming anytime soon. We think an expansion of it is more likely. As Apple is XLK's main holding and comprises more of it than the S&P, this behemoth's outperformance will benefit those who own more XLK relative to SPY.

Medium-Term Outlook for XLK


Our Head of Research Tom Lee, has recommended owning cyclical stocks since the March crash. We still recommend these stocks for more aggressive investors. However, even for the most aggressive investors, we still recommend holding a 'bar-bell' like a position in some high-quality growth and technology stocks as the conservative element instead of bonds. So, we are not denigrating those who say there will be a rotation in the cyclically sensitive "epicenter" stocks that we also recommend.

We simultaneously think the XLK will continue to outperform. If you’re risk-averse, we think it's still a pretty safe bet to tell you you'll outperform the S&P if you're overweight XLK. Not least of which because the worsening COVID-19 situation will lead some investors to continue sticking with what works, especially those dipping their feet into a 'risk-on' attitude. Also, much of the demand for 'epicenter' names come from the cash on the sidelines, so the Epicenter's rise at Technology's expense isn’t a foregone conclusion.


Again, while we understand at a superficial level why so many pundits are claiming that technology's outperformance will necessarily diminish as money goes from those Tech Stocks directly to worst-affected cyclical stocks. The only problem with this assessment is that there are still many investors who have anomalously high amounts of cash on the sideline. There is roughly $4.5 trillion of cash on the sidelines. That is a lot, and not all of it will go to the highest performing cyclical sectors. This was already bearish capital; there will likely be plenty of demand for XLK in the future because of this. We’ve also seen this cash returning at a slow and skeptical pace. Particularly given the now rising cases of coronavirus and difficulty in the approval and vaccine logistics, the coming violent rotation into cyclical stocks will be hard to time. Still, we continue to assign an outperform rating for XLK at the short and medium-term investment horizons for this article.

Long-Term/Secular Outlook for Technology

We are also bullish on the Information Technology sector over a three to five-year time horizon. We have thematic strategic portfolios that cover this time horizon, and they cover three trends that we believe will lead to significant overperformance. All three of these trends are favorable, to greater degrees for some companies than others, to many of the names that are holdings of XLK.

The first trend we see as a major long-term bullish catalyst for XLK is the massive transfer of wealth that has begun from baby boomers to millennials and the latter generation entering their prime earning and borrowing years. As they become more and mature in their economic life-cycles, we have seen that they have a major penchant for growth and technology stocks.


The second secular trend we think will drive returns over the next three to five years is driven by a secular global labor shortage. We think that the macroeconomic incentive here benefits the technology sector twofold. Firstly, companies will need to meet output with less human labor, meaning they will consume more services from companies that help them through automation and artificial intelligence to achieve the same effect with less human labor, and cost. Many of the primary holdings of XLK are well-positioned to take advantage of this trend.

The third portfolio favors companies that get to profitability using assets and capital investment rather than operating leverage to make money. In other words, this is picking companies that use assets efficiently to get to profitability; a key example of a company fitting this profile would be AAPL. According to the Federal Reserve, another COVID-19 specific element in this thesis is that despite all the economic headwinds, the demand for goods actually increased. The demand for in-person, face-to-face services has declined for obvious reasons. However, many of the services Technology companies provide, even those with high asset-intensity elements, are less susceptible as their services are primarily conducted in the digital realm, which is booming.

There are many reasons to be constructive on equities despite political and viral headwinds. The main reason is an accommodative Federal Reserve with all but guaranteed low-bound interest rates for the next three to four years. We also see this as a long-term bullish driver for the price of XLK.


Let’s compare options markets between the SPY and XLK. Implied volatility is one of the key metrics needed to determine a mark price for any derivative. When implied volatility of an option increases it means there is also a relative increase in its price compared to other options. Generally, implied volatility can be used as a contrarian indicator. Lower implied volatilities may suggest a contrarian buying opportunity.



When we compare the options markets and levels of implied volatility between SPY and XLK a few things are immediately clear. Firstly, as we would expect given the poor developments with regard to coronavirus, there is a parity between puts and calls favoring puts, when using monthly expirations, meaning that the market is generally bearishly positioned. However, the put/call ratios tell a story of a market that is clearly more bullish on XLK than SPY. XLK’s put/call ratio is 1.18 while SPY’s put/call ratio is significantly higher at 1.28.

Risks and Where We Could Be Wrong

It is difficult to assess many risks that would knock Tech off its axis given its performance over the last year through some of the worst conditions markets have ever had to face. However, as the path of the virus in the United States is getting significantly worse, we do not want to pretend that XLK is fully insulated from the consequences of a very bad third wave. It is not. However, even in the event of a bear market, we still would bet that Tech continues an outperformance. We have noticed that the market hasn’t been going down in lockstep with rising coronavirus cases as it did in wave 2 and particularly in wave 1. There could be many explanations for this, but the one we find most compelling is that the rates of hospitalization and death has remained muted compared to the earlier waves.

As you can see, cases per million in wave 3 states have skyrocketed to previously unprecedented levels. However, as we will show you below, the death rate has gone down in each successive wave as therapeutics improve, and potentially a ‘dead-wood’ issue in that vulnerable populations have already been culled, or are more astute in their behavior to avoid the virus.


The second major risk falls under the umbrella of geopolitical tensions between China and The United States. Of course, this secondary risk is more unlikely than the primary geopolitical risk to the global economy. This would be a continued escalation of tensions between the world’s two largest economies, China and the United States.

To a lesser degree, political uncertainty in the United States continues to create a muddled picture for when the inevitable, and much needed, next wave of stimulus will arrive. Economic data has begun to underperform and stimulus is needed for the continued resilience of the consumer.

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