Jim Paulsen: Here's what's really behind the tech stock drop

Published Thu, Jun 15 20171:43 PM EDT

Jim Paulsen, Independent Investment Strategist

Key Points

The S&P 500 Information Technology Sector Stock Price Index has declined by almost 5 percent since its peak on June 8th.
Currently, there is little evidence U.S. economic momentum is improving.
Most perceive the recent pullback in technology stocks as a valuation adjustment.

The S & P 500 Information Technology Sector Stock Price Index has declined by almost 5 percent since its peak on June 8th. Many believe this represents an overdue valuation adjustment after the index soared by about 40 percent in the last year. Certainly, a refreshing pause after such an aggressive run makes sense. However, rather than necessarily signaling an overvalued sector, we believe the recent pullback in tech stocks may be a reaction to a forthcoming reacceleration in U.S. economic momentum. The enclosed chart overlays the U.S. economic surprise index (blue) with the relative stock price performance of the S & P Financials sector compared to S & P Technology sector (orange). As shown, in the last several years, the directional movement (but not necessarily the magnitude) in the relative performance of finance/tech stocks has been closely associated with U.S. economic momentum. Slower economic momentum tends to magnify the value of technology stocks when internally-generated growth (growth which typically is not dependent on the pace of overall economic growth) often characteristic of the technology sector becomes much more scarce and valuable compared to slowing growth prospects among other economically-sensitive sectors. Conversely, finance stocks are punished by falling or low yields which result from sluggish economic momentum. Likewise, improving economic momentum diminishes the value of technology stocks while enhancing the earnings potential of financial stocks. Note that the relative performance of finance/tech stocks tends to lead economic momentum. The relative sector performance bottomed in Feb. 2014, March 2015, April 2016 and again in September 2016. Economic momentum bottomed only with a lag in April 2014, May 2015, May 2016 and again in October 2016. Similarly, the relative sector performance peaked in April 2014, August 2015, May 2016 and again in December 2016 while economic momentum did not peak until June 2014, November 2015, July 2016 and finally in March 2016, respectively. Currently, there is little evidence U.S. economic momentum is improving. Indeed, the Citi economic surprise index just declined this morning to its lowest level in about two years. However, the dramatic outperformance of financial stocks above technology stocks in the last couple weeks may be suggesting economic momentum will again soon improve. Technology stocks began outpacing strongly at the end of last year while financial stocks stopped outpacing even though U.S. economic momentum continued to improve until March. Now, technology stocks are underperforming and financial stocks are outpacing even though current U.S. economic momentum remains weak. Most perceive the recent pullback in technology stocks as a valuation adjustment. While this may be playing a role, we believe current stock market action indicates a more important event. As the enclosed chart illustrates, the recent relative price outperformance of finance stocks above tech stocks may be signaling a forthcoming reacceleration in U.S. economic momentum. This year began with strong and expanding U.S. economic momentum even though tech stocks started to outpace and financials and other cyclical sectors did poorly. Indeed, most defensive stock sectors (e.g., utilities and consumer staples) stopped underperforming once the year began even though economic momentum continued to strengthen. Then, many questioned why financials stopped outperforming even though economic momentum was still rising. However, the improved performance of technology and other defensive sectors combined with the underperformance of financials and other cyclical sectors correctly forewarned that U.S. economic momentum was about to slow as it did beginning in March. Now, despite increasing fears that weak U.S. economic momentum and tightening by the Federal Reserve is enhancing recession risk, the relative performance of finance stocks relative to technology stocks may similarly suggest investors should prepare for improved U.S. economic momentum. Paulsen, the former chief investment strategist for Wells Capital Management, has spent more than three decades on Wall Street. This note was republished with his permission.

Jim Paulsen

Adam Jeffery | CNBC