Prefer tech, semiconductors and utilities: Pettit

Key Concepts

Tech Stock Weakness: Current market pressure on technology stocks, leading to the NASDAQ's worst week since April.
Data Drought: Absence of key economic reports (like the jobs report) due to the US government shutdown.
Market Fundamentals: Underlying economic and company-specific factors that drive market performance.
Profit Taking: Investors selling assets after a period of gains to secure profits.
Growth Expectations: Market pricing of significant future earnings growth for tech companies (e.g., 20% compounded annually).
Fair Valuation: When a stock's price reflects its expected future earnings and growth.
AI Technology: Artificial intelligence and its impact on productivity and company valuations.
Leveraged and Inverse ETFs: Investment vehicles used for short-term trading, amplifying gains or losses.
Retail Investor Behavior: Analysis of how individual investors use trading tools, particularly ETFs.
Average Holding Period: The typical duration retail investors hold specific types of investments.
Small Cap Stocks: Stocks of companies with smaller market capitalization, often associated with higher growth potential.
US Domestic Economy: The state and outlook of the United States' internal economic activity.
Cyclical Stocks: Companies whose performance is tied to the broader economic cycle.
GARP (Growth at a Reasonable Price): An investment strategy that seeks growth stocks trading at attractive valuations.
Earnings Growth Inflection: A point where a company's earnings growth is expected to accelerate.
Improving Margins: A company's ability to increase its profit margins.
Asset Turnover: A measure of how efficiently a company uses its assets to generate sales.
MKS Incorporated (MKSI): A tech company supplying instruments and chemical products for semiconductor manufacturing.
MasTec (MTZ): An American infrastructure company involved in electricity buildout.

Tech Stock Weakness and Market Fundamentals

The NASDAQ is experiencing its worst week since April, with continued pressure on tech stocks. This weakness is attributed to a combination of factors, including a "data drought" caused by the US government shutdown, which has halted the release of crucial economic reports like the jobs report.

Drew Petta, Director of US Equity Strategy at City, suggests that the current weakness in tech stocks is a "normal blip" rather than a fundamental shift. He argues that the longer-run fundamentals for tech remain intact, and that strong earnings have led to a situation where investors are "priced for great." This setup provides a natural reason for investors to take profits and "take some money off the table." Petta notes that this profit-taking behavior was anticipated coming into earnings season and that his firm still favors tech and growth stocks, viewing the current pullback as an opportunity to buy.

Market Pricing and Investor Behavior

A key point of discussion is how markets are pricing in significant future growth for tech stocks, with expectations of around 20% compounded annual growth for the next three years. When earnings reports confirm these high expectations but do not exceed them, the stocks are considered "fairly valued." In such scenarios, a "normal behavior" is for investors to book profits.

Petta highlights that while investors are excited about AI technology developments and productivity gains, the prices of these stocks have "really run ahead of what the fundamental trajectories can support." He contrasts "healthy behavior," which involves taking profits during such market conditions, with "unhealthy behavior," which is "levering up and keep chasing these things higher and higher." He views these types of volatility events as beneficial in a bull market, as they can help sustain the market's upward trend for longer periods.

Analysis of Retail Investor Use of ETFs

Petta discusses an analysis tool that tracks retail investors' use of leveraged and inverse ETFs, which are typically short-term trading vehicles. While it's common for leveraged products to hold more assets when the market is rising, the key insight lies in the behavior of these investors.

Selling on Upside Moves: When there are significant upward moves in the market, retail investors are observed to be selling these leveraged ETFs.
Short Holding Periods: The average holding period for these ETFs is estimated to be around four days. This indicates a tactical approach where investors enter and exit positions quickly to capture short-term gains.

Petta characterizes this behavior as "pretty good and smart tactical use," where investors hold for a short period and sell when they see a pop. He emphasizes that as long as these behaviors remain in place, they are considered "healthy" and not indicative of irrational exuberance or performance chasing.

Asset Class Recommendations

When asked about asset classes to emphasize, Petta offers the following:

NASDAQ on Pullbacks: He reiterates his liking for the NASDAQ when it experiences pullbacks.
US Small Cap: For new money, small-cap stocks are presented as a "really interesting place." This is because small caps are expected to have positive earnings growth next year for the first time in two years.
Growth on a Pullback: For existing equity allocations, Petta suggests buying growth stocks on a pullback.
GARP Approaches: Within the growth category, he favors "Growth at a Reasonable Price" (GARP) strategies.
Small Cap and Cyclicals: Within these segments, the focus is on companies whose quality is set to improve next year, specifically looking for "inflections in earnings growth and improving margins."

Outlook on the US Economy and Small Caps

Petta expresses a positive view on the state of American growth, despite anticipating some softening in employment numbers and mixed signals from non-government data. He believes that if the US avoids a recession, there will be enough of a "tailwind coming off of uncertainty this year in trade" to drive earnings growth from negative to positive for many cyclical companies. This is a significant shift, as cyclical companies have not experienced this for a long time.

He reinforces the rationale for buying small-cap stocks: their growth potential. The fact that their earnings have been stagnant for two years and are now poised to grow is a key driver. Petta's base case is that this bull market will continue, and there are "more things that could work into 2026."

Stock Ideas

Petta provides two specific stock ideas:

MKS Incorporated (MKSI):
- Description: A tech company that supplies instruments and chemical products used in semiconductor manufacturing.
- Rationale: While large-cap semiconductor names are strong, Petta sees a "broadening out in tech." He likes the fundamental trajectories of companies like MKS, where investors can find "better value" and apply AI and GARP principles by moving down the market capitalization scale. He expects more upside as earnings revisions move higher for such names.
MasTec (MTZ):
- Description: An American infrastructure company involved in areas like electricity buildout.
- Rationale: Petta focuses on the fundamentals, noting that MasTec is expected to see "margins improve into next year and the year after." Additionally, its "asset turnover pick up as well," indicating improving efficiency. He categorizes this as a cyclical company demonstrating "improving quality," which is precisely the type of inflection he looks to buy into for 2026.

Conclusion

The discussion emphasizes that the current tech stock weakness is likely a healthy profit-taking phase within a broader bull market, driven by high growth expectations that have outpaced current fundamentals. Retail investor behavior, particularly their tactical use of leveraged ETFs, suggests a cautious but not irrational approach. The outlook for the US economy is cautiously optimistic, supporting a positive view on small-cap and cyclical stocks that are poised for earnings growth and quality improvements. Specific investment opportunities are identified in the semiconductor supply chain (MKS) and infrastructure (MasTec) sectors, based on their improving fundamental trajectories.