Category Archives: Context and Perspectives

While The Market Regained Some of Its Footing, It’s Shaky At Best

While The Market Regained Some of Its Footing, It’s Shaky At Best

 

Key Points from This Report:

  • Did the election matter?
  • Italy is a growing problem for the Eurozone and U.S. Investors should care
  • The rising dollar and interest rates
  • Another strong jobs report – be careful what you wish for
  • More signs that the global economy is slowing
  • The trade war with China continues with no end in sight.
  • The Market has found at least some shaky footing

 

Did the Election Matter?

The big news of the week was the non-news of the election, which gave both sides sufficient wins to claim victory. The market engaged in what was likely a brief “thank-God-there-were-no-surprises-this-time” rally the following day. For investors, the election means that any further tax cuts are highly unlikely and while the need for infrastructure spending is something both parties agree on, the budget process for that spending has the potential to be reminiscent of a Jerry Springer episode – let the games begin.

We’ll probably hear more threats concerning impeachment, but the election results make it unlikely that will be anything more than the usual vitriol coming out of the beltway these days. Overall the election ended up being a non-event, followed by a relief rally… but several issues remain that could complicate matters for the market and investors.

 

Italy is a growing problem for the Eurozone and U.S. Investors should care

Italy continues to vex both the eurozone and those pundits who insist that cooler heads will prevail. I live a good portion of my time in Italy and I can assure you, there are no cooler heads in Italy’s leadership and its citizenry are becoming more and more enraged by their governments’ endless inability to address the myriad of issues facing the nation, regardless of which party or coalition is in charge. Keep in mind that Italy faces even more challenging demographics than the U.S., (which in comparison is akin to our Aging of the Population investing theme on steroids) as its population is skewed even older thanks to insanely high youth unemployment, which drives many of the young to look outside their birth country for better opportunities.

The U.S. isn’t alone in its desperate need for infrastructure investment. Remember that bridge in Genoa, Italy that collapsed in August killing 43 people? Despite the promises in the days following the tragedy that the nation’s leadership would mobilize all available resources immediately and get a new bridge for this vital part of the region’s infrastructure up as soon as humanly possible, nothing has been done.

Not.

One.

Damn.

Thing.

And that is just a bridge. Last week the nation was hit with massive storms that caused an incredible amount of damage, inflicting even more pain on a country that is already a mess. I expect Italy will not be the one to blink first when it comes to the revised budget due to Brussels later this month. There will be a showdown with the rest of the Eurozone and it is going to get even messier.

For some perspective, just 10 years ago Luigi Di Maio, the leader of the Five Star Movement and Deputy Prime Minister, was living with his parents and working as a drinks server at the Napoli stadium. In just 10 years he’s gone from one of those guys walking around, hocking drinks from his tray, to leading Italy. Is it any wonder that the rest of Europe’s leadership isn’t exactly thrilled with Italy’s leadership choices?

Adding to the drama, France’s leader, Emmanuel Macron, looks to be struggling under all the pressure and Germany’s Angela Merkel is now a lame-duck having announced she is stepping down as the leader of her party and will not be seeking reelection. Europe is without strong leadership at a time when it desperately needs it. This is going to get worse before it gets better.

Why should investors care what happens in Italy?

The eurozone economy is nearly the size of the United States’ and Italy is both too big to save and too big to fail without putting the entire region into an economic tizzy. Italy has the potential to seriously rock the markets at a time when interest rates are rising most everywhere, and dollar liquidity is shrinking.

 

The rising dollar and interest rates

With global liquidity shrinking at the fastest pace since 2008, the dollar continues to strengthen, causing a variety of problems for a broad swath of market participants. The strong dollar has been causing pain in the commodity complex and those economies tied to it, for example, this week U.S. West Texas Intermediate (WTI) crude fell more than 21% from last month’s four year high. The recent strong jobs reports mean the Fed is likely to continue on its rate hike path and Thursday’s post-meeting announcement referred to a strengthening labor market and economic activity rising at a strong rate – pretty much like the Bat-signal for more hikes coming. The lack of foreign buyers of Treasury auctions is adding to rate pressures. So far in calendar year 2018, we have seen half the level of foreign buying we saw in 2017.

 

Another strong jobs report – be careful what you wish for

Last month businesses added an additional 250k to the U.S. workforce, well above the expected roughly 200k, but the real number would have been even more incredible had it not been for the 198k that were not at work due to weather conditions – a level three times the historical norm thanks to Hurricane Michael. Without Mike, the number would have been closer to +400k, so while Wall Street is getting serious jitters as the bears have been pacing around the major indices, Main Street is busy hiring. Break out the champagne and party hats?

Err, not so fast. As much as I love a glass of the chilled bubbly, digging into the details gets me a bit nervous to see that while construction activity has been contracting for several quarters, the sector has added 100k to its ranks since July. Contracting activity levels while growing payrolls? Not exactly good for the bottom line. The Federal Reserve’s Beige book has been a compendium of executive angst over the impact of trade wars on their businesses, but transportation services grew their ranks by 25k, the most in 13 months. This is likely because 100% of the net new jobs over the past four months have gone to those with a high school education or less. Great for the development of skills in that cohort, not so great for their employers who are experiencing lower productivity levels, which translates into earnings pressure for investors.

Cocktail Investing Podcast Episode 85We also saw wages rise +3.1% year-over in October from +2.8% in September, the fastest rate since 2009. We suspect consumers in our Middle-class Squeeze investing theme are cheering as are retailers that are gearing up for the 2018 holiday shopping season – for more on that, check out this week’s Cocktail Investing Podcast where we talk with the National Retail Federation and its consumer survey findings for holiday shopping this year.

Back to the October wage gains, we strongly suspect the Fed is watching as increased pay pressures have pulled 711k into the workforce, which pushed the labor force participation rate up by +0.02% in October. Without the new entrants into the workforce, the unemployment rate would have dropped to 3.3%, which would be the lowest level in 65 years!

So, jobs look fantastic right? Errrmmmmm, yes but… the manufacturing workweek was cut a second time by 0.2% since June to the lowest number of hours since January – could be the trade war is cutting folks’ hours. Overall, the labor market is exceptionally tight so no wonder the Fed this week announced that “The labor market has continued to strengthen and … economic activity has been rising at a strong rate,” keeping in place its plan to continue to gradually raise rates.

 

More signs that the global economy is slowing

While the US is still humming along, most are not paying attention to the slowing happenings outside our borders. The IHS Markit Composite PMI in the euro area dropped to a 2-year low of 53.1 in October from 54.1 in September while Italy dropped to its lowest level since November and is now in contraction territory- anything below 50 is in contraction. Germany’s real manufacturing orders year-over-year declined -2.2%. Eurozone GDP slowed to a 5-year low in Q3 of a less than +1% annual rate. The US will not be unaffected by the slowing outside its borders.

 

The trade war with China continues with no end in sight.

We’ve already talked a lot about this in previous weeks, so we will just leave this one with a note that China is looking to regain its place as the world’s dominant nation and its leader has his job for life. The strange events surrounding many high-profile people ranging from the leader of Interpol to actress Fan Bingbing to Alibaba’s Jack Ma give the impression that some seriously strange things are going on in the nation and perhaps the CCP leadership is looking to close ranks and tighten its grip – there is going to be a lot more to this story in the months and years to come.

 

The Market has found at least some shaky footing

Finally, after a brutal October, the market has managed to regain some of the ground it lost in the early days of November but let me point out that it is unusual for the S&P 500 to lose 10% or more twice in any given year. Going back roughly half a century, such double dipping typically precedes or occurred in conjunction with a recession, (with the exception of 1987 which wasn’t much fun).

As earnings season is nearing a close, corporate share buyback programs have been able to restart their purchases, helping put a (temporary?) floor under the market. I remain warry that we haven’t seen the end of this period of volatility.

 

October Buy-the-Dip Trick or Treat?

October Buy-the-Dip Trick or Treat?

 

So much for the typical October strength in equities – a month in which the major US indices historically have gained ground 75% of the time. We’ve seen major index support levels broken while earnings beats have been smaller than we’ve seen over the past year with revenue and forward guidance giving investors jitters.

Over the summer and through September we warned that this earnings season would likely be a very bumpy ride as earnings would probably be decent, but guidance would not support the market’s multiples. Our concerns have proven warranted. Overall this earnings season the average company that has reported saw its shares fall 2% on its earnings reaction day – if this keeps up it will be the worst stock performance reaction on record since 2001.

How bad has it been?

  • On Wednesday, October 24, the Nasdaq had its worst daily drop since 2011, closing the day down over 10% from its recent highs and by the close of the trading day, the Dow Jones Industrial Average and the S&P 500 had lost all their gains for the year. If the market’s close in the red again Friday, the S&P 500 will have closed down 15 days during the month thus far, the most since 2012.
  • The FAANGM stocks entered a bear market this week, losing 4.4% on Wednesday – the worst decline since August 2011.
  • The Global MSCI All World Index hit a 14-month low, in bear market territory with a more than 20% decline since the January highs, losing 11% in October alone – the biggest decline since the financial crisis. This week only 4 of the 47 countries in the MSCI all country world index were above their 200-day moving average.
  • Homebuilder stocks have fallen more than 40% from their January highs – the canary in the consumer coal mine. New home sales plunged 5.5% in September versus expectations for a -0.6% decline as the supply of homes for sale rose +2.8% (the sixth consecutive increase) to the highest level since 2008 while demand has fallen to a 2-year low. Tell me again how great that consumer is doing and how they might contend with 5% mortgages? As those homes become more expensive to purchase, fewer Middle-Class Squeeze consumers will be filling out a mortgage application.
  • The only two S&P 500 sectors in the green this month are defensive – Consumer Staples (+1%) in the midst of its longest winning streak since November 2009 and Utilities (+3%). Even one of the must-have lifelines for our Digital Lifestyle investing theme mobile service wasn’t a safe haven as AT&T (T) shares fell some 9% this week hitting a new 52-week low in the process.
  • This week the Russell 2000 small cap index fell over 15% from its highs, closing Wednesday just 5 points away from a new 52-week low.
  • After spending 262 consecutive days above its 200-day moving average, oil closed this week below that marker. Streaks of such magnitude have only happened two other times over the past 30 years – April 10, 2000, which ended a 272-day streak and September 2, 2008, which ended a 330-day streak. Those dates are worth noting.
  • The first 18 trading days in October have seen a daily open to close loss 83.3% of the time, besting the previous 75% record in September of 2000. If the market rallies from open to close on the next 4 trading days, October’s closed in the red versus open will be 65.2% of days – the worst for any single month since October 2008 which was at the height of the financial crisis – and that is the very BEST we could hope for.

Investors are taking note with the weekly sentiment survey from AAII reporting that bullish sentiment fell to 27.9% from 34%, the fourth weakest reading for bullish sentiment this year. Bearish sentiment rose from 35% to 41%, the highest reading since the last week of June. Other indicators, such as the CNN Fear & Greed Index which fell to Extreme Fear (6) this week from Greed (64) a month ago, also point to increasing investor unease.

 

What is driving all this is the market starting to sync up with the reality of geopolitics and economics.

  • The era of central bank continual infusions of liquidity is over. The flow has not only stopped, but in the case of the US, reversed course.
  • We are facing trade wars and tariffs. The recent Federal Reserve Beige book was packed full of executives complaining about the impact of such on their businesses.
  • A decent portion of the domestic economic acceleration has been thanks to unsustainable fiscal deficits. The market is just starting to figure that out as the headlines move from cheerleaders to more rationale skeptics. Our Safety & Security investing theme is making headlines as a solid portion of growth has been driven by increases in defense spending which shifted from an average annual -2.1% rate of decline from June 2009 to March 2017 to a +2.9% average annual rate of increase since April 2017.
  • The Italian problem is not going away. It is too big to save and to say its current leadership is incompetent is putting it mildly, (as someone who lives a good portion of my time in Genoa of the collapsed bridge fame) and the clock is ticking on its sovereign debt bomb. As an example of the breathtaking level of incompetence, after two months basically no progress has been made on replacing that bridge despite its vital importance to not only Italy’s economy but to the greater Eurozone given its link to a major port.
  • China is in a full bear market, its economy is saddled with a staggering level of debt, and the Chinese yuan has dropped to its lowest level versus the dollar in a decade. We are watching these and other data points with an eye toward our Rise of the Global Middle-Class investing theme.
  • Geopolitical tensions are mounting around the world and the current Saudi situation highlights just how much the balance of global power is shifting.

 

The big question is where do we go from here?

Just 13% of stocks in the S&P 500 are above their 200-day moving average – these are mostly in the aforementioned Consumer Staples and Utilities sectors. This level has only occurred a few times in the past, marking just how oversold near-term the market has become. There is not one Energy or Industrial sector stock above its 50-day moving average. Rebounds are to be expected with such near-term oversold conditions.

Looking at the economics, the Citigroup Global Economic Surprise Index has been in negative territory, (meaning more data coming in below expectations than above) since April – the longest stretch in 4 years. The October Eurozone PMI fell to a 25-month low. Back in the US, the Richmond Federal Reserve local business conditions index for services hit a 7-year low, similar to what we’ve seen on the manufacturing side.

The employment situation is increasingly worrisome. The Richmond Fed’s wage expectations index for 6 months out recently jumped dramatically up to a level not seen since March 2000 as the available pool of labor has dropped to an 11-year low. Looking at who has been getting jobs recently, 70% of job gains over the past 6 months and 100% over the past 4 months have gone to folks with just a high-school degree or less. While we love to see more people getting jobs, from the corporate side of things, that means that companies are having to hire those with the weakest skill set. Great for the person getting a job as they can now develop more skills, but brutal for the employer who is facing weaker productivity as a result – that hurts earnings which are already facing rising costs from tariffs and trade wars as well as rising interest rates.

The bottom line is we are likely to see some interim rebounds, but it doesn’t look like the market is yet in sync with global realities. We have been pointing out for months that US stocks indices have been outperforming the rest of the world to a degree that was simply not sustainable.

The market is starting to appreciate the magnitude of the fiscal stimulus economic sugar high, that trade wars aren’t so easily won, that geopolitical risks are material, that the change in central bank liquidity flows matters and that future earnings growth is likely slower. We haven’t even gotten started when it comes to the fireworks I’m expecting from the Italian situation. We are likely to see the occasional rebound, but my money is that more pain is yet to come. That is great news for those that are focused on solid, long-term investing themes like the ones we have developed at Tematica Research, and have a shopping list of stocks ready for the bargains that will be coming our way.

 

 

Is Now the Time to Panic?

Is Now the Time to Panic?

What we are currently seeing in the market is a symptom of a whole lot of leverage in equities that had been in rich territory at a time when, even though it is still moving along, signs abound that the economy is slowing. Is this a ‘buy the dip’ opportunity or is it just the start of a much bigger downturn?

It has been a stormy week from the onslaught of hurricane Michael to the sea of red in global equity markets as the market shift we have been awaiting finally took hold. Wednesday the Dow lost over 800 points and had its worst day since February. The S&P 500 has had its worst losing streak in two years with over half of the S&P 500 at least two standard deviations below their 50-day moving average – the highest such percentage since March. A full two-thirds of the S&P 500 is now down 10% or more from their respective highs – that is a broad-based decline. The Russell 2000 has blown through all support levels down through its 200-day moving average. The once high-flying NYSE FANG+ Index has fallen more than 16% from its recent highs. All 65 members of the S&P 500 Tech sector closed in the red Wednesday, something we haven’t seen since the beginning of April.

Outside the US markets have been struggling even more – the US is just starting to catch up. Germany’s DAX is down to 6-month lows, the MSCI Asia-Pac Index hit a 17-month low, the Emerging Market index hit a 19-month low and 13 of the 47 members of the MSCI all-country index are down 10% or more year-to-date. Korea hasn’t seen a decline like this in 7 years. Taiwan hasn’t seen a decline of this magnitude in over 10 years. China’s Shanghai and Shenzhen Indices are at levels not seen since 2014. For those who regularly read on commentary on TematicaResearch.com, we’ve been pointing out for months that the large outperformance of US equities versus the rest of the world was unsustainable.

 

The big question on everyone’s mind now is, “Is this a ‘buy the dip’ opportunity or is this just the start of a much bigger downturn and what should we expect as we head into earnings season?”

Let’s start with earnings season which is likely to see the reporting quarter’s performance decent relative to expectations, so I’m not worried about meeting target numbers. What I am worried about is investor reactions and guidance. Since mid-September 48 of the S&P 1500 companies have reported and while their results relative to performance have been solid, only 10 companies have traded higher on their earnings day and the average stock has declined 3.8% on the day. This is an acceleration of the reactions we saw from investors last quarter.

Expectations are being adjusted. Over the past month, analysts have raised forecasts for 358 companies in the S&P 1500 and lowered them for 534 which is a net of 12.2% of the index adjusted downward, the most negative EPS revision spread since March 2017. We’d warned earlier in the year that the benefits from tax cuts and the massive injection of federal spending would likely translate into weakness in the later part of the year – well, here you have it. We are no longer seeing dramatic increases in earnings estimates while corporate guidance is slowing shifting to the downside.

Looking at factors affecting forward guidance, we are seeing rising costs across a broad range of inputs – energy, tight labor markets, higher interest rates and let’s not forget everyone’s favorite ongoing trade war. Earnings season also means that one of the major buyers of equities, companies themselves, is forced to sit on the sidelines for some time.

The big picture here is that global liquidity conditions have materially changed as central banks have shifted gears in an environment that is full of extremes.

  • Banks are shedding assets with several having announced layoffs in the credit loan groups as credit growth has been slowing.
  • China and Japan, two of America’s largest creditors to the tune of over $1 trillion, are reducing their exposure to Treasuries at a time when the nation is running fiscal deficits typically only seen during a war or major recession with debt to GDP reaching levels not seen since World War II.
  • This year the net flows into US mutual funds and ETFs is 46% below that experienced in the first three quarters of last year.

 

This contracting liquidity is occurring in the context of a variety of extreme conditions.

  • The recent tax cuts and federal spending boon represents the largest stimulus to the economy outside of a recession since the 1960s, that at a time when the economy is already above full employment.
  • We’ve seen an explosion in debt across the globe with the ratio of global debt to GDP rising from 179% in 2007 to 217% today, according to the Bank for International Settlements.
  • According to S&P Global Ratings, the percent of companies considered highly-leveraged (with debt-to-earnings ratio of 5x or more) has risen from 32% in 2007 to 37% in 2017 – so much for healthy balance sheets in the corporate sector.
  • Around 47% of all investment grade corporate debt is in the lowest category (BBB-rated) both in the US and Europe, versus just 35% and 19% respectively in 2007.
  • Total US non-financial corporate debt as a percent of GDP is near a post-World War II high.
  • The quality of corporate debt is at extreme levels as well with 75% of total leverage loan issuance in 2017 covenant-lite versus 29% in 2007.
  • There was an estimated $8.3 trillion in dollar-denominated emerging-market debt at the end of 2017, according to the Institute of International Finance, accounting for over 75% of all EM debt. According to Bloomberg, some $249 billion needs to be repaid or refinanced through next year with the US dollar having strengthened considerably against their local currencies, making that debt all the more expensive.
  • It isn’t just debt that is at extreme levels as the percent of household net worth in equities has never been higher.

 

The Bottomline on the Recent Market Turmoil

We’ve got a whole lot of leverage in the system with equities that had been in rich territory at a time when while the economy is still moving along, signs of slowing abound. Is this time to panic? Definitely not. The US stock market is getting in sync with what has been happening with yields, what is going on outside the US and with more realistic growth prospects. Both myself and Chris Versace, Tematica’s Chief Investment Officer, will be examining and re-examining thematic signals identify well-positioned companies in light of our 10 investing themes. This means being on the lookout for confirming data points that give comfort and conviction for positions existing Thematic Leader positions and opportunities to scale into them at better prices. It also means building a shopping list of thematically well-positioned companies to buy at more favorable prices.

This means asking questions like “Where will the company’s business be in 12-18 months as these tailwinds and its own maneuverings play out?”

A great example is Amazon (AMZN), which our regular readers know continues to benefit from our Digital Lifestyle investment theme and the shift to digital shopping, as well as cloud adoption, which is part of our Digital Infrastructure theme and with its significant pricing power, our Middle-Class Squeeze theme which focuses on the cash-strapped portion of the population. And before too long, Amazon will own online pharmacy PillPack and become a key player in our Aging of the Population theme. Amid the market selloff, however, the company continues to improve its thematic position. First, a home insurance partnership with insurance company Travelers (TRV) should help spur sales of Amazon Echo speakers and security devices. This follows a similar partnering with ADT (ADT), and both arrangements mean Amazon is indeed focused on improving its position in our Safety & Security investing theme. Second, Bloomberg is reporting that Amazon Web Services has inked a total of $1 billion in new cloud deals with SAP (SAP) and Symantec (SYMC). That’s a hefty shot in the arm for the Amazon business that is a central part of our Digital Infrastructure theme and is one that delivered revenue of $6.1 billion and roughly half of the Amazon’s overall profits in the June 2018 quarter.

At almost the same time, Alphabet/Google (GOOGL) announced it has dropped out of the bidding for the $10 billion cloud computing contract with the Department of Defense. Google cited concerns over the use of Artificial Intelligence as well as certain aspects of the contract being out of the scope of its current government certifications. This move likely cements the view that Amazon Web Services is the front-runner for the Joint Enterprise Defense Infrastructure cloud (JEDI), but we can’t rule our Microsoft or others as yet. I’ll continue to monitor these developments in the coming days and weeks, but winning that contract would mean Wall Street will have to adjust its expectations for one of Amazon’s most profitable businesses higher.

Those are a number of positives for Amazon that will play out not in the next few days but in the coming 12-18+ months. It’s those kinds of signals that team Tematica will be focused on even more so in the coming days and weeks.

 

Changes Afoot at S&P, But They Still Lag Our Thematic Investing Approach

Changes Afoot at S&P, But They Still Lag Our Thematic Investing Approach

Revisions to S&P’s Global Industry Classification Standard (GICS) means big changes to mutual fund and ETF holdings that tracks one of several indices, but were these reclassifications outdated before they even launched?

 

While many investor eyes were focused on the latest round of escalation in the current trade war between the US and China, there was a major change about to take place that would affect people’s investments going forward. In the last week of September, S&P rolled out the largest revision to its Global Industry Classification Standard (GICS) since 1999. Before we dismiss it as yet another piece of Wall Street lingo, it’s important to know that GICS is widely used by portfolio managers and investors to classify companies across 11 sectors. With the inclusion of a new category – Communication Services – it means big changes that can alter an investor’s holdings in a mutual fund or ETF that tracks one of several indices. That shifting of trillions of dollars makes it a pretty big deal on a number of fronts, but it also confirms the shortcomings associated with sector-based investing that we here at Tematica have been calling out for quite some time.

The new GICS category, Communications Services, will replace the Telecom Sector category and include companies that are seen as providing platforms for communication. It will also include companies in the Consumer Discretionary Sector that have been classified in the Media and Internet & Direct Marketing Retail subindustries and some companies from the Information Technology sector. According to S&P, 16 Consumer Discretionary stocks (22% of the sector) will be reclassified as Communications Services as will 7 Information Technology stocks (20% of that sector) as will AT&T (T), Verizon (VZ) and CenturyLink (CTL). Other companies that are folded in include Apple (AAPL), Google (GOOGL), The Walt Disney Co. (DIS), Twitter (TWTR), Snap (SNAP), Netflix (NFLX), Comcast (CMCSA), and DISH Network (DISH) among others.

 

 

After these maneuverings are complete, it’s estimated Communication services will be the largest category in the S&P 500 at around 10% of the index leaving weightings for the other 11 sectors in a very different place compared to their history. In other words, some 50 companies are moving into this category and out of others. That will have meaningful implications for mutual funds and ETFs that track these various index components and could lead to some extra volatility as investors and management companies make their adjustments. For example, the Technology Select Sector SPDR ETF (XLK), which tracks the S&P Technology Select Sector Index, contained 10 companies among its 74 holdings that are being rechristened as part of Communications Services. It so happens that XLK is one of the two largest sector funds by assets under management – the other one is the Consumer Discretionary Select Sector SPDR Fund (XLY), which had exposure to 16 companies that are moving into Communications Services.

So what are these moves really trying to accomplish?

The simple answer is they taking an out-of-date classification system of 11 sectors – and are attempting to make them more relevant to changes and developments that have occurred over the last 20 years. For example:

  • Was Apple a smartphone company 20 years ago? No.
  • Did Netflix exist 20 years ago? No.
  • Did Amazon (AMZN) have Amazon Prime Video let alone Amazon Prime 20 year ago? No.
  • Was Facebook (FB) around back then? Nope. Should it have been in Consumer Discretionary, to begin with alongside McDonald’s (MCD) and Ralph Lauren (RL)? Certainly not.
  • Did Verizon even consider owning Yahoo or AOL in 1999? Probably not.

 

What we’ve seen with these companies and others has been a morphing of their business models as the various economic, technological, psychographic, demographic and other landscapes around them have changed. It’s what they should be doing, and is the basis for our thematic investment approach — the strong companies will adapt to these evolving tailwinds, while others will sadly fall by the wayside.

These changes, however, expose the shortcomings of sector-based investing. Simply viewing the market through a sector lens fails to capture the real world tailwinds and catalysts that are driving structural changes inside industries, forcing companies to adapt. That’s far better captured in thematic investing, which focuses on those changing landscapes and the tailwinds as well as headwinds that arise and are driving not just sales but operating profit inside of companies.

For example, under the new schema, Microsoft (MSFT) will be in the Communications Services category, but the vast majority of its sales and profits are derived from its Office software. While Disney owns ESPN and is embarking on its own streaming services, both are far from generating the lion’s share of sales and profits. This likely means their movement into Communications Services is cosmetic in nature and could be premature. This echoes recent concern over the recent changes in the S&P 500 and S&P 100 indices, which have been criticized as S&P trying to make them more relevant than actually reflecting their stated investment strategy. For the S&P 500 that is being a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies by market value.

As much as we could find fault with the changes, we can’t help it if those institutions, at their core, stick to their outdated thinking. As I have said before about other companies, change is difficult and takes time. And to be fair, for what they do, S&P is good at it, which is why we use them to calculate the NJCU New Jersey 50 Index as part of my work New Jersey City University.

Is this reclassification to update GICS and corresponding indices a step in the right direction?

It is, but it is more like a half step or even a quarter step. There is far more work to be done to make GICS as relevant as it needs to be, not just in today’s world, but the one we are moving into.

That’s especially true compared to the thematic approach that we employ. As we see it, there is a major distinction between grouping companies based on a sector classification – one of 12 choices – vs. doing so based on the tailwinds that are driving their businesses, especially as companies acquire and divest businesses that will have a pronounced impact on their business model.

For example, while Walt Disney competes with the content business at Comcast Corp. (CMCSA), it doesn’t have a cable network or other communications business like Comcast, Charter Communications (CHTR) or Verizon. AT&T (T) is in the midst of acquiring Time Warner that would dramatically alter its business mix and product strategy, but how does the Communications Sector view account for that? Gaming companies such as Activision Blizzard (ATVI) and Take-Two (TTWO) are consuming network data with linked, multi-player games, but are they each more a gaming and content company than a Communications Services company?

And so on…

These shortcomings reveal the flaws with grouping companies and their business models by sectors, which Webster’s Dictionary defines as “a distinct part of society or an economy.” Inherent in this sector based classification schema is the idea that companies don’t change their business model. As we’ve witnessed over the years, Amazon has continued to add to its business model and today is delivering all sorts of products and services that are a long way off of its original book based business. Complicating the sector based classification further is Amazon Web Services, its pending acquisition of online pharmacy PillPack and the rollout of its Amazon Go stores that employ technology that could change the retail shopping experience entirely. Then there is Amazon’s Prime Video offering that stream TV shows, movies, original content and NFL games, it’s Prime music service as well as its Whole Foods business. Oh yeah, and then there is its Alexa/Echo digital assistant business that is moving beyond smart speakers to being incorporated into appliances, cars and home security services.

Is Amazon a Consumer Discretionary company? Is it a Communications Services company like Walt Disney and CBS or a Consumer Staples company like Kroger (KR)? Or does Amazon’s burgeoning home security capabilities mean one day it will be an Industrial company alongside ADT?

We could go on, but odds are you get the point – trying to sandwich companies into 12 sectors is not always easy, and in some cases, it could be quickly dated.

That’s why we prefer our thematic approach that evaluates each company against the changing landscapes of economics, demographics, technology development, psychographics, regulatory mandates and others. These intersections get to the heart of the how and why a business’s customers are altering their behaviors, changing the required value equation for companies along the way. Viewed through that lens it comes as little surprise that brick & mortar retail companies are struggling, shelf-stable and frozen food companies are suffering, why beverage companies are on a renewed acquisition frenzy, and fast food companies are reinventing their menu and overhauling the food and drinks they serve.