Why a record high for this little-known index is a bullish signal

semiconductor-chip-circuit

Financial markets have made a roaring start to 2017, with the FTSE 100, Dow Jones and S&P 500 climbing to all-time highs.

Last night (25 January) the Dow Jones climbed above the 20,000 point mark for the first time, spurred on by hopes that new president Donald Trump will deliver on his pledges to put more money back into the pockets by cutting taxes.

Trump has also promised an infrastructure spending spree. The markets have lapped up the prospect of a new era of reflation borne out of fiscal policy and have moved higher as a result.

Some investors, including Richard Buxton, manager of the Old Mutual UK Alpha fund, are concerned this may turn out to be a classic case of markets moving too quickly, too soon.

CORRECTION POSSIBLE

In a wide-ranging interview with Money Observer as part of our Money Maker series, which will appear in the March magazine, Buxton adds the caveat that the positive run markets have enjoyed since the US presidential election last November hinges heavily on Donald Trump's pledged tax cuts and spending sprees bearing fruit.

'A market correction may well play out in the second half of the year; markets are going up in hope that Trump's policies will be signed off, but there is always a danger that when markets are travelling higher they melt-up in euphoria,' says Buxton.

'There's also a risk of US growth undershooting expectations. It could take longer than expected for Trump's fiscal policies to feed through to economic activity.'

But in the short term at least market momentum remains, evidenced by the performance of the little-known Philadelphia Semiconductor Index, known as the SOX.

The index, which is home to 30 businesses that develop and manufacture microchips, is considered a useful indicator as to whether America's S&P 500 index will extend its strong run or suffer from a market correction.

Russ Mould, of AJ Bell, explains that the fact the SOX index is currently trading at a record high (as shown in the chart, click to enlarge) is a positive sign.

'The SOX is currently trading at a new record high and investors will therefore be pleased that the (silicon) chips are up.

'The technology benchmark has historically been a good guide to where America's S&P 500 index, and by implication the world, might go, as the US is the biggest and most influential stock market of all,' Mould explains.

WHERE THE US GOES, THE UK WILL FOLLOW

'Since Trump's election last November the SOX is up by nearly 14 per cent against a 6.6 per cent gain from the S&P 500, because silicon chip (and silicon chip production equipment) makers are seen as a good proxy for global growth - semiconductors can be found in almost anything, from computers to medical scanners, aircraft to cars and smart phones to smart-meters.

'The SOX index tends to pull markets lower as well as higher, and good numbers are needed to justify its stunning 2016 gains, so investors should take heed if the benchmark begins to lose altitude.'

philadelphia-semiconductor-index-versus-s-and-p-500

On virtually every valuation measure the US stock market looks expensive, particularly the Shiller price/earnings ratio, scoring 27.3 versus its long run average of 16.7. Does this indicate the market is ripe for a fall?

Not necessarily, according to Brian Dennehy of FundExpert.co.uk, who makes the point that stock markets can stay overvalued for years and become even more expensive. 'The US market is still somewhat cheaper than in 1999, a crazy time,' says Dennehy.

'Nonetheless the US market is overdue a correction (a market fall of up to 20 per cent). For example, since 1928 a 20 per cent correction occurs a bit less than every two years – it is now over five years since the last 20 per cent correction. This is very stretched.

'Investors should be aware of the extreme US overvaluation, and also remember that where the US goes the UK will follow.'


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