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Technology ETF: XLK No. 3 Select Sector SPDR In 2014

Summary The Technology exchange-traded fund finished third by return among the nine Select Sector SPDRs in 2014. As it did so, the ETF was weak at the beginning and the end of the year, while strong in the months in-between. Seasonality analysis of the first quarter is a mixed bag, but my data interpretation suggests a constrained return. The Technology Select Sector SPDR ETF (NYSEARCA: XLK ) in 2014 ranked No. 3 by return among the Select Sector SPDRs that cleave the S&P 500 into nine fragments. On an adjusted closing daily share-price basis, XLK climbed to $41.35 from $35.09, a hike of $6.26, or 17.84 percent. It thus behaved better than its parent proxy, the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) by 4.38 percentage points, but worse than its sibling, the Utilities Select Sector SPDR ETF (NYSEARCA: XLU ) by -10.90 points. (XLK closed at $41.25 Friday.) XLK ranked No. 7 among the sector SPDRs in the fourth quarter, when it lagged XLU and SPY by -9.00 and -0.72 percentage points, in that order. And XLK ranked No. 9 among the sector SPDRs in December, when it performed worse than XLU and SPY by -5.75 and -1.92 percentage points, respectively. Figure 1: XLK Monthly Change, 2014 Vs. 1999-2013 Mean (click to enlarge) Source: This J.J.’s Risky Business chart is based on analyses of adjusted closing monthly share prices at Yahoo Finance . XLK behaved a lot better in 2014 than it did during its initial 15 full years of existence based on the monthly means calculated by employing data associated with that historical time frame (Figure 1). The same data set shows the average year’s weakest quarter was the third, with an absolutely large negative return, and its strongest quarter was the fourth, with an absolutely large positive return. Inconsistent with this pattern, the ETF had excellent gains each and every quarter last year. Figure 2: XLK Monthly Change, 2014 Versus 1999-2013 Median (click to enlarge) Source: This J.J.’s Risky Business chart is based on analyses of adjusted closing monthly share prices at Yahoo Finance. XLK also performed a lot better in 2014 than it did during its initial 15 full years of existence based on the monthly medians calculated by using data associated with that historical time frame (Figure 2). The same data set shows the average year’s weakest quarter was the second, with a relatively small positive return, and its strongest quarter was the fourth, with an absolutely large positive return. Meanwhile, there is a big difference between the monthly mean and median performances of the ETF in Q1: Personally, I parse the relevant data more bearishly (consistent with the mean) and less bullishly (inconsistent with the median) in the current context. Figure 3: XLK’s Top 10 Holdings and P/E-G Ratios, Jan. 9 (click to enlarge) Note: The XLK holding-weight-by-percentage scale is on the left (green), and the company price/earnings-to-growth ratio scale is on the right (red). Source: This J.J.’s Risky Business chart is based on data at the XLK microsite and FinViz.com (both current as of Jan. 9). XLK appears poorly positioned to be a standout among the Select Sector SPDRs, either this quarter or this year, given factors discussed in “PowerShares QQQ’s 2014 And Fourth-Quarter Performance And Seasonality.” Basically, I anticipate one of the biggest headwinds buffeting the U.S. technology sector in general and XLK in particular over the foreseeable future may be the bias divergence in monetary policy at major central banks around the world. On the one hand, the U.S. Federal Reserve is oriented toward tightening; on the other hand, the Bank of Japan, European Central Bank and People’s Bank of China are oriented toward loosening. This divergence has had important effects on exchange rates, such as in the euro and U.S. dollar currency pair, or EUR/USD. It is worth mentioning in this context that the Fed announced the end of asset purchases under its latest quantitative-easing program, aka QE3+, Oct. 29 and may announce the beginning of interest-rate hikes April 29. Its conclusion of purchases under its first two formal QE programs this century is associated with both a correction and a bear market in large-capitalization equities, as evidenced by SPY’s declines of -17.19 percent in 2010 and -21.69 percent in 2011. The bias divergence at the major central banks has been reflected by action in the EUR/USD cross, which slipped from as high as $1.3992 May 8 to as low as $1.1753 Jan. 8, a slide of -$0.2239, or -16.00 percent, based on data at StockCharts.com. This change in EUR/USD and similar moves in other currency pairs indicate a strengthening greenback and a weakening everything else could pressure earnings of U.S. companies in sectors with substantial international businesses. And XLK encompasses many firms fitting this description, with its exposure to either the tech or the telecommunications sectors at about 100 percent, per its microsite. Meanwhile, the valuations of the ETF’s top 10 holdings seem unlikely to function as tailwinds for it this quarter (Figure 3). Nonetheless, the S&P 500 information-technology sector does not strike me as hideously overvalued, with S&P Senior Index Analyst Howard Silverblatt reporting Dec. 31 its P/E-G ratio was 1.20. Of course, it was a different story with the index’s telecommunications-services sector, with Silverblatt reporting at the same time its P/E-G ratio was 2.16. Disclaimer: The opinions expressed herein by the author do not constitute an investment recommendation, and they are unsuitable for employment in the making of investment decisions. The opinions expressed herein address only certain aspects of potential investment in any securities and cannot substitute for comprehensive investment analysis. The opinions expressed herein are based on an incomplete set of information, illustrative in nature, and limited in scope. In addition, the opinions expressed herein reflect the author’s best judgment as of the date of publication, and they are subject to change without notice.

Generating Alpha With A 2015 Model Portfolio

Summary 2015 will be a volatile year, and only the great stock pickers will come out significantly ahead. Don’t look for the needle in the haystack. Just buy the haystack! Taking the Jack Bogle approach might be the best way to mitigate risk and avoid unnecessary volatility. The first (and only) email request sent to SAFoundationalResearch@gmail.com was a request to create a model portfolio against the S&P 500. The weightings below are what we recommend for 2015: S&P 500 Recommendation Equity Sectors Weight Weight Difference Consumer Discretionary 12.0% 12.0% 0.0% Consumer Staples 9.9% 10.9% 1.0% Energy 8.3% 10.3% 2.0% Financials 16.5% 18.0% 1.5% Heathcare 14.5% 16.0% 1.5% Industrials 10.4% 8.9% -1.5% Information Technology 19.7% 19.7% 0.0% Materials 3.2% 3.2% 0.0% Telecom 2.3% 0.0% -2.3% Utilities 3.2% 1.0% -2.2% We fundamentally believe that 2015 will be a volatile year, and only the great stock pickers will come out significantly ahead. That being said, this portfolio will take the Jack Bogle approach and will strictly purchase SPDR ETFs. “Don’t look for the needle in the haystack. Just buy the haystack!” – Jack Bogle Some other rules for this $100,000 model portfolio: Opportunity to rebalance quarterly (but not required) Must be within +/-3% of the sector benchmark Must be at least 80% invested at all times Recommended $100,000 Model Portfolio Ticker Price as of Jan 2, 2015 Number of Shares Consumer Discretionary Select Sector SPDR ETF (NYSEARCA: XLY ) 72.15 166 Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ) 48.49 224 Energy Select Sector SPDR ETF (NYSEARCA: XLE ) 79.16 130 Financial Select Sector SPDR ETF (NYSEARCA: XLF ) 24.73 727 Health Care Select Sector SPDR ETF (NYSEARCA: XLV ) 68.38 233 Industrial Select Sector SPDR ETF (NYSEARCA: XLI ) 56.58 157 Technology Select Sector SPDR ETF (NYSEARCA: XLK ) 41.35 476 Materials Select Sector SPDR ETF (NYSEARCA: XLB ) 48.58 65 Utilities Select Sector SPDR ETF (NYSEARCA: XLU ) 47.22 21 Cash 244.31 244.31 After this article, Foundational Research will post a series of articles for each sector and the respective industries. Below are some highlights on half of the sectors: Technology Sector Highlights We remain cautious on the technology sector, and recommend an equal weight. Although the sector, as measured by the XLK, has outperformed the broader market in 2015, much of that is due to AAPL, which accounts for more than 16% of the XLK index. We also believe the shift to cloud computing will have a negative impact on earnings for most large-cap technology companies, especially over the next few years, when the highest switching over/expenditure costs are expected. Valuations are also higher than they used to be, with overall tech trading at a 22% premium to the 5-year median P/E and a 70% premium to trough valuation, but the Technology sector still trades at a -9% discount to the S&P 500. Telecommunications Sector Highlights News flow continues to be almost exclusively negative in the telecommunications sector. Pricing is likely to continue to be a problem in wireless, and the wireline business is in secular decline. The negative pricing/promotion backdrop in wireless accelerated this past year. While the competitive condition may take a seasonal respite early this year following the holidays, the intermediate-term prospects in this regard is for more of the same, in our opinion. That is, more brutal competition. Energy Sector Highlights The downturn in crude oil prices and the prices for oil & natural gas-related stocks accelerated to the downside over the two quarters. Demand continued to suffer from weak economic conditions and/or slowing economic growth, particularly in the eurozone and China. At the same time, investors were spooked by ongoing strong oil production growth from US unconventional basins and the recovery of disrupted output from Libya. There was also the risk that the sanctions on Iran might be reduced or eliminated, potentially opening the way for increased production (approx. +500,000-700,000 barrels/d). Finally, OPEC was not able to come to an agreement to cut production to balance the market, leading to a sizeable drop in oil prices the day after Thanksgiving. We believe that the share prices have over-reacted to the crude oil price drop. Historically speaking, whenever energy stocks have lead decline for six months, they then lead for the following six months. “This time is different” often leads investors astray. Industrial Sector Highlights We are concerned that reductions to oil & gas capital spending budgets will have an outsized impact on the machinery and electrical equipment industries. There appears to be an expectation that better consumer spending trends following cheaper gasoline prices will spur further capital spending from the consumer discretionary sector. This may be the case, but we’d expect any pickup in capex from the discretionary sector to take time, while the cuts from the oil & gas complex will be more immediate. Additionally, sales into the oil & gas complex are among the most profitable for our companies, and will be difficult to replace (even if there is a pickup in consumer discretionary capex). Consumer Discretionary Highlights The market weight recommendation on the consumer discretionary sector reflects a more balanced view of the tailwinds and headwinds facing the group over this year. Fairly significant 2014 underperformance in the group has led to more reasonable relative valuations of late, and that, coupled with falling gas prices (a potential benefit to the consumer) and easing top line/margin comparisons in F15 have resulted in a more balanced risk/reward. That being said, many near-term macro data points remain mixed (i.e. jobs, housing, food commodity costs) and could keep a lid on overall earnings growth, which prevents a more constructive view on the group, for now. Material Sector Highlights Downstream is the new upstream. While we retain our neutral recommendation on the complex, we favor downstream/processed/refined-related commodity companies that benefit from the decline in upstream pricing. The perfect storm of increased production, stemming from higher prices, followed by slowing demand growth has resulted in a backdrop where many upstream commodities are in “oversupply.” The stronger United States dollar is only adding fuel to the fire. We would remain positioned in those commodities that benefit from falling inputs and oligopolic behavior. Our two preferred commodities are steel and aluminum, with the former capitalizing on falling iron ore prices, and the latter on falling power prices. We would avoid copper and iron ore where we have yet to see price support, as the cost curve continues to decline. Consumer Staples Highlights The third-quarter earnings results certainly did not encourage us to change our view. The operating environment remains challenging for packaged goods companies, especially so for food companies, yet the consumer staples sector continues to make new highs. Investors seem to continue to seek out yield, and probably even more so, stability, as we move toward year-end. Category growth remains sluggish in developing markets, and has slowed in emerging markets. The currency headwinds have intensified for many companies. Domestic attempts to drive volume with more promotions have not been as successful as in the past. The debate continues as to whether there has not been enough innovation or the consumer is still in a constrained in spending mode – we believe it has. Healthcare Highlights We continue to believe the Patient Protection and Affordable Care Act (ACA) will be a positive force in healthcare for the next 3-5 years, with some potential ramifications that need to be watched. As we approach year 2 of the expansion part of the law, Republicans have taken control of the Senate, and the Supreme Court has decided to review another case relating to the legislation. Scientific breakthroughs are creating a cornucopia of new biopharmaceuticals for unmet or poorly served medical needs. The demographics of the major industrialized nations, including North America, Europe, and Japan, are changing to larger populations of elderly patients, who are major consumers of drugs. Utilities Highlights We see nothing operationally wrong with the Utilities sector. The reach for yield has caused share prices to increase. Without a capex increase, and with prices as high as they are, we believe they will not appreciate any further. The last time the Utilities sector lead the market over the course of a year, as it did in 2014, it only returned 1% total return the next year. Over the next few weeks, we will go in-depth on each sector, so please remember to “Follow” us to not miss anything!