Merrill Strategists Underweight Communications After Facebook, Google Added

Merrill Lynch equity and quant strategists are underweighting the new communications services sector even though the firm’s fundamental strategists have positive outlooks on Facebook and Google, which constitute about 40% of the new sector’s weighting.

The strategists, led by Savita Subramanian, write in their latest outlook that the new communications sector could come under pressure from rising interest rates, which would “pressure high dividend yielders,” from regulatory concerns about privacy and from a “broadening of U.S. economic growth,” which could drive investors out of “crowded secular growth internet stocks into less crowded GDP-sensitive sectors.”

(Related: A Massive Shift in Stock Sector Classifications Starts Today)

The strategists are also concerned about more aggressive capital expenditures by companies in the new sector. Big-spending, high-growth stocks tend to underperform, while the opposite tends to be true for industrials and select tech stocks that did not move to the new communications sector, according to the report.

On the flip side, the strategists note the strong balance sheets and advertising spending, cash return and disruptive strengths of Google and Facebook, the heaviest hitters in the new index. “An underweight view on Communication Services is not an easy call to make.”

Merrill Lynch strategists are overweighting sectors that generate cash flow rather than use it. “Our sector outlook incorporates the one thing we know with some certainty: that cash yields are likely to move higher, not lower, in the next year or two.”

With that in mind, the strategists are overweight tech, health care, financials and industrials. All but tech have cheap valuations relative to recent (industrial) or more distant history (health care and financials), as well as other favorable attributes.

Tech, for example, is the only one whose strong balance sheets have more cash than debt, and they benefit from heavy exposure to momentum and secular growth factors that tend to do well at the end of bull markets, according to the strategists.

In addition to communications, they are underweight utilities, real estate and consumer discretionary stocks, one of the two pre-existing sectors most affected by the new Global Industry Classification Standard (GICS) regime that created the new communications services sector. Several stocks in each moved out into the new communications sector. In addition to Google and Facebook, they include Netflix, Comcast and Disney, which moved from consumer discretionary into the communications sector.

Consumer discretionary stocks consistently underperform when the Federal Reserve is hiking rates and like communications sector stocks are overweighted by large-cap active funds, according to the Merrill strategists.