A wild start to 2022 … what sector rotation tells us about where the broad market is headed … is it time to exit tech stocks?

Well, that was a wild way to start 2022.

Below, we look at the major indices on the week (as of mid-afternoon on Friday).

In short, we enjoyed a rally to kick off the new year on Monday…which proceeded to smash headfirst into the hawkish minutes from the Fed’s December meeting, which sent stocks tumbling.

The weakness continues as I write, thanks to today’s disappointing payroll number. It came in at just 199,000 for December, missing the forecast of 422,000 by miles.

Looking at the entire week, the Nasdaq whipsawed the hardest, doing a round-trip reversal of roughly 5% from top to bottom.

But if you’re worried this is the end of market bullishness, hold on.

***On Wednesday, our technical experts, John Jagerson and Wade Hansen, pointed toward why they believe stocks will resume their upward march

For newer Digest readers, John and Wade are the analysts behind Strategic Trader, InvestorPlace’s premier trading service. It combines options, insightful technical and fundamental analysis, and market history to trade the markets, whether they’re up, down, or sideways.

In their Wednesday update, they wrote that we’re not seeing investors pulling cash out of the market; rather, they’re rotating sectors.

And when investors allocate into the sectors that are getting the love today, it usually points toward economic expansion ahead. That’s good for the economy and overall investment markets.

Here’s more from John and Wade:

Watching which sectors traders are rotating money into and out of tells us a lot about the sentiment on Wall Street.

Looking at a comparison chart of the ten S&P 500 sectors, and the S&P 500 itself (tracked by State Street Global Advisors through their Select Sector SPDR funds), you will see the following performance since Dec. 20:

• Energy Select Sector SPDR® Fund (XLE): 13.21%
• Consumer Discretionary Select Sector SPDR® Fund (XLY): 8.90%
• Financial Select Sector SPDR® Fund (XLF): 8.12%
• Industrial Select Sector SPDR® Fund (XLI): 7.20%
• Materials Select Sector SPDR® Fund (XLB): 7.19%
• SPDR® S&P 500 Fund (SPY): 4.90%
• Consumer Staples Select Sector SPDR® Fund (XLP): 4.38%
• Technology Select Sector SPDR® Fund (XLK): 4.14%
• Utilities Select Sector SPDR® Fund (XLU): 2.21%
• Real Estate Select Sector SPDR® Fund (XLRE): 1.81%
• Health Care Select Sector SPDR® Fund (XLV): 1.27%

Figure 2 – Sector Comparison Chart

As you can see, the energy, consumer discretionary, financial, industrial, and basic materials sectors have been driving the bullish uptrend.

These are the exact sectors we would expect to see outperforming when Wall Street believes there is further economic expansion ahead.

You can see this illustrated in the Business Cycle chart in Figure 3.

Figure 3 – Stock Sector Performance During the Business Cycle

With the exceptions of energy stocks doing so well because the price of oil is rebounding and technology stocks not doing quite as well because Treasury yields are rising, traders are plowing money into the sectors that typically benefit from economic expansion.

***But what about the sectors that have been hemorrhaging capital – specifically, tech?

Tech stocks have powered the returns of countless mom ‘n pop portfolios over the last decade. Does this shift in the Fed’s monetary policy mean the tech ride is over?

For that, let’s turn to our hypergrowth specialist, Luke Lango.

For newer Digest readers, Luke is the analyst behind Early Stage Investor. His specialty is finding market-leading tech innovators that are pioneering explosive trends, capable of generating outsized investor wealth.

Of course, tech innovators are especially sensitive to interest rates. That means the market environment we’re entering could mean more pain for tech investors.

So, what are we to make of all this?

It boils down to one general idea…

Yes, “tech” is likely in for more selling pressure, but specific, elite tech stocks are going to be fine. However, this distinction means it’s critical to know which type of tech you’re holding.

Here’s Luke to present the macro case against the average, bread-and-butter stock:

Right now, investors are fearful of the Fed pulling liquidity out of the market in 2022 via both rate hikes and a balance sheet run-off – two things that pretty much all Fed members agreed were appropriate to do in the coming year.

On a macro scale, these fears are justified.

The stock market has expanded to valuation multiples that are reliant upon that excess liquidity. Our valuation models indicate that, if the Fed does hike rates multiple times this year and reduce its balance sheet holdings, the S&P 500’s earnings multiple will have to contract meaningfully.

It will be up to earnings growth to offset that contraction, and we’re wary that there’s enough earnings growth firepower to do that.

Not especially encouraging.

So, how should a tech investor respond?

***In writing for his Early Stage Investor subscribers, Luke points out the differences between the holdings in their portfolio versus an “average” tech stock that could be a portfolio timebomb

The differences serve as a helpful litmus test you can use to evaluate the tech stocks in your own portfolio today.

The first is valuation.

Have your tech stocks already sold-off down to more attractive valuations? Or do prices remain lofty, leaving them vulnerable to a sharp correction?

Here’s Luke describing the stocks in his Early Stage Investor portfolio:

The valuations on (our) stocks have already taken a haircut in anticipation of Fed rate hikes. The repricing has already happened.

Therefore, we actually believe many of our stocks are due for multiple expansion in 2022 – not contraction, as may be the case for the rest of the market.

Luke’s second point intertwines with valuations.

He points toward sales and earnings, which are obviously the denominators in the most widely-used valuation metrics of price-to-sales and price-to-earnings ratios.

Back to Luke:

One of the biggest concerns about the market is that it needs earnings growth to be robust in 2022 to offset multiple contraction, but Fed rate hikes will likely hamper earnings growth by throttling consumer demand and the economy.

(The tech stocks you want to own) are powered by secular growth drivers and don’t need a robust economy to sustain robust sales growth.

As you look at your tech portfolio, where’s the growth coming from? Is it dependent on a robust economy? Or will broad secular tailwinds support it?

Third, remember to maintain a big-picture perspective.

Unless your specific circumstances require you to pull money from the market in the short-term, it’s important to think “multi-year growth story.”

From Luke:

The most important thing to remember here is that, while it may seem like all the market cares about today is the Fed, this is really just noise in the big picture. It’s a near-term event that will pass.

The Fed has tightened and loosened monetary policy dozens of times over the past two decades, and while those cycles created market volatility, they ultimately didn’t stop the likes of Netflix, Amazon, Microsoft, Apple, Nvidia, Facebook, and more from soaring hundreds of percent.

We’re invested in the next-generation of those companies, so we are not too concerned with how Fed-induced volatility impacts our stocks over the course of a few days, weeks, months, or even quarters.

We’re invested for the long haul.

***Putting it all together

Let’s sum up…

If we look at what’s happening in the broad market, strength remains. We’re just seeing money sloshing around.

Here’s John and Wade’s bottom-line:

We expect the S&P 500 to consolidate above its up-trending support level at 4,720 as Wall Street gets ready for earnings season to kick off in mid-January.

There will be plenty of price movement and volatility in individual stocks…but on average, we expect the major indexes to hold steady.

And zeroing in on tech stocks in particular, it’s time to make sure your holdings are rooted in fundamental strength. The broad tech sector is running into headwinds, so we can’t count on a rising-tide-lifts-all-ships environment.

You want only the strongest tech, boosted by powerful organic earnings driven by secular growth stories.

Here’s Luke’s simple sum-up to take us out:

In the long-run, good businesses that make good products and services are the best investments.

Have a good evening,

Jeff Remsburg