As Milestones Are Crossed, Be Selective

A Record-Setting Week for Stocks

Stocks around the world rewrote the record books last week. In the United States, the Nasdaq Composite Index eclipsed its 2000 peak, advancing 3.26% to close the week at 5,092. In Japan, the Nikkei Index climbed above 20,000 for the first time in 15 years, while China's equity market continues to defy gravity. Meanwhile, the S&P 500 Index rose 1.72% to 2,117 and the Dow Jones Industrial Average was up 1.42% to 18,080. As for bonds, the yield on the 10-year Treasury rose from 1.87% to 1.91% as its price correspondingly fell.

Such milestones are just numbers, but they do offer an opportunity to assess where we are. Our take is that U.S. technology stocks are not in a bubble, unlike in 2000. However, we would exercise some caution, or at least selectivity, particularly with respect to China, where the A-Share market appears increasingly frothy.

2015 Is Not Y2K

Last week, U.S. stocks were once again aided by merger-and-acquisition activity, with Teva Pharmaceuticals making an unsolicited $40 billion bid to take over Mylan. "Good enough" earnings also provided a measure of support. While IBM and Facebook missed analysts' expectations, partly due to the dollar's strength, Caterpillar, Amazon, Microsoft and Morgan Stanley all posted strong numbers.

The rally in stocks that has pushed the Nasdaq Composite to new highs is seen by some as a sign of another tech bubble. In reality, however, valuations in the sector look more sober today than back in 2000.

The current multiple on the sector is roughly 19.5 times trailing earnings, only about 5% higher than the broader market and not much changed over the past year. In contrast, in March of 2000, the U.S. technology sector was trading at over 72 times earnings, more than double the market's valuation. The year leading up to the bursting of the tech bubble in 2000 was marked by relentless multiple expansion, a one-year climb of more than 50%.

Another key differentiator today: The tech sector represents a more modest portion of the overall stock market. At their peak, technology stocks accounted for roughly 30% of total U.S. market capitalization; today, the weight is around 20%. Technology actually is once again the largest weighting in the S&P 500, but it is far less dominant than it was back in 2000. Still, while we continue to favor the technology sector, we would focus on the mature tech companies with real earnings.

While we continue to favor the technology sector, we would focus on the mature tech companies with real earnings.

Pick Your Spots in Asia

The milestones were not limited to the U.S. last week. Recently, Japan's Nikkei 225 Index closed above 20,000 for the first time in 15 years. Stocks in Taiwan also hit a 15-year high on hopes for a direct trading link with China.

Despite more negative news from China––a soft manufacturing number and the first default by a state-owned enterprise––Chinese A-Shares, which are traded in Shanghai, continued their advance. The catalyst was a full one percentage point cut in the reserve requirement ratio (the amount of cash a bank is required to hold relative to its assets), the second such reduction since February. While this was the biggest cut since 2008, it mainly counteracts the loss of liquidity from recent capital outflows.

Still, hopes for further stimulus continue to ignite China's equity market. But we are seeing some worrisome signs of increasing speculation on the part of investors. For example, following a rule change allowing for multiple accounts, mainland stock investors opened 3.25 million new accounts, a record. In addition, margin debt––in other words, borrowing to buy stocks––has risen sharply in recent weeks.

While we continue to believe Asian equities represent an interesting opportunity, we would be selective. For example, we favor shifting our China exposure to the H-Share market, which is traded in Hong Kong. We are not seeing the same excesses in this part of the market and valuations are much more reasonable. H-Shares are trading at less than half the current valuation of the A-Share market.

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