FSI Sector Allocation - February 2025 Update Array ( [cookie] => 3a3950-5daf69-c1b974-698dbf-d7a652 [current_usage] => 1 [max_usage] => 2 [current_usage_crypto] => 0 [max_usage_crypto] => 2 [lock] => [message] => [error] => [active_member] => 0 [subscriber] => 0 [role] => [visitor_id] => 0 [reason] => Usage under limits [method] => ) 1 and can accesss 1

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Market Recap

The equity market has been choppy since mid-December. While the release of DeepSeek’s new R1 model shook the market and particularly the AI infrastructure sector, the overall market demonstrated strong resilience. The S&P 500 gained approximately 2.7% in January, led by Communication Services and Healthcare, up by 9.0% and 6.6%, respectively. Technology was the only sector in the red, declining 2.9%.

Overall, equities started 2025 strong and are tracking better than our base case. As Tom noted, several factors indicate a better-than-expected market trajectory in 2025:

• First 5 Days Rule –  While the first five days account for only 2% of the year’s 250 trading days, they often set the tone for the entire year. Historically, when the prior year saw a gain of over 10%, and the first five trading days of the new year posted gains, the market ended the year higher 82% of the time, with a median gain of 13%. In 2025, the S&P 500 rose 0.62% in the first five days, signaling a positive start.

• January Barometer –  Similar to the First 5 Days Rule, the old Wall Street adage says, “As January goes, so goes the year.” With the S&P 500 gaining 2.7% in January, history suggests an 89% win ratio and an median 19% FY return following a positive January.

• Sentiment Capitulation – The AAII net bull-bear spread dropped to -15 in January, the lowest reading since October 2023. Historically, such extreme bearish sentiment has been a reliable contrarian indicator, often signaling a market bottom.

• Softer Inflation Data  – December CPI and PPI both came in softer than expected. Additionally, the BLS New Tenant Rent Index posted a shocking negative year-over-year (YoY) change for Q4 2024—the first such decline since GFC. A Richmond Fed study suggests that this index generally leads the CPI Rent of Shelter component by three quarters, implying that housing inflation could plummet in the next 6-9 months, potentially turning negative.

• Dovish Fed – the FOMC meeting reinforced a dovish outlook. Although the Fed removed the phrase “inflation has made progress toward the Committee’s 2% objective” from its statement, Powell’s press conference noted positive inflation data recently and potential easing in shelter inflation. To us, this is a patient Fed, focusing on incoming inflation data and policy changes from the White House.

While Trump’s inauguration did not trigger major market disruptions initially, last Friday’s tariff threats against Canada, Mexico, and China raised investor concerns. As Tom pointed out in First Word, a detailed reading of the Executive Order suggests significant differences from the 2018 trade war—it may be more accurately termed a “Drug War” rather than “Trade War”.

While increased trade tensions introduce uncertainty and lack of visibility, which investors do not appreciate, we believe the market may overreact in the short term. If this trade dispute remains contained and short-lived, any risk-off could be viewed as buying opportunities.

4Q24 earnings so far has been a good catalyst to the market. By the end of January, 181 companies (36% of the S&P 500) had reported earnings. 79% beat EPS estimates, with an average surprise of 5%. This is a solid result though below the 5-year average of 8% and the 10-year average of 7%.

Communication Services and Financials are the strongest sectors:

• Communication Services: 100% beat with 12.4% average surprise
• Financials: 91% beat with 11.6% average surprise

Compared to 4Q2023, the S&P 500 is projected to grow 13.4% YoY, led by Financials and Broader Technology.

Interestingly, outside of commodity sectors and Consumer Staples, Industrials earnings are expected to decline 10.9% YoY, which is almost entirely due to Boeing (BA 0.70% ).

Semiconductors and AI infrastructure names, especially NVDA, are still under scrutiny following the release of the DeepSeek R1 model.

To us, the release of DeepSeek is more of a breakthrough (or a validation of a previously anticipated breakthrough) rather than a destructive event:

• Improvement in efficiency has been consistent with recent cycles of development – This chart from X.com caught my eye. As you can see, cost efficiency has been consistently improving, either through hardware advancements or better software algorithms. Personally, I wonder whether the market would have reacted this negatively if the breakthrough had come from an American firm instead of DeepSeek, a lesser-known company based in China.

• Secondly, the distillation technology likely used by DeepSeek is not an industry secret. In fact, to some extent, this can be seen as a compromise necessitated by the lack of large-scale access to NVIDIA GPUs by Chinese companies. While there may be ethical and legal concerns about whether proprietary closed-source models can be used to train competing models, from an overall AI development perspective, this does not represent a complete disruption of the existing model.

That said, the key question is whether this will undermine the demand for AI infrastructure (chips, data centers, power grids, and energy). While this is likely to be a shock to AI-exposed stocks in the short-term, we do not believe it will fundamentally alter the AI landscape. As mentioned earlier, this type of efficiency improvement has happened multiple times over the past two years, yet we haven’t seen the market previously worry about AI demand.

An analogy we discussed internally was that improving a car’s fuel efficiency (mpg) makes driving more economical and increases accessibility, rather than simply concluding it would reduce the overall gasoline consumption.

Mark Zuckerberg also reiterated during last week’s META earnings call that the DeepSeek breakthrough is unlikely to change AI spending trajectories. He emphasized that their massive AI infrastructure investment will continue to provide a strategic advantage, stating:

So in short, while the recent weakness may not recover immediately, especially given the tariff headwinds, we view this as a buying opportunity.

Sector Ratings

While Tom’s sector ratings remain the same, Mark made two upgrades in the latest sector allocation model:

• Basic Materials is upgraded from Underweight to Neutral – The rollover of the US dollar in the second half of January helped recover 38.2% retracement of the decline in Q4 last year. Despite the tariff news last Friday and over the weekend, which caused the US dollar index to surge again, if this trade dispute is short-lived, we could see the dollar index resume its rollover, benefiting precious and base metals and their stocks.

• Healthcare is upgraded from Underweight to Overweight – The healthcare sector has bounced back well since the Fed’s hawkish cut on December 18. In fact, healthcare has been the third-best performing sector since then (only Communication Services and Financials performed better). The message remains the same as last month, where Mark believes healthcare could see a 3-6 month mean-reversion bounce. Therefore, given its recent strength, Mark has tactically upgraded it to Overweight.

Within the 11 GICS 1 sectors, Tom and Mark share the same view on 7 sectors:

• Overweighted by both: Consumer Discretionary, Industrials, Tech, Financials
• Neutral by both: Materials, Utilities
• Underweight by both: Consumer Staples

For the remaining 4 sectors:

 – Communication Services and Real Estate: Overweighted by Tom, Neutral rated by Mark

• Energy: Neutral by Tom, Underweighted by Mark
• Healthcare: Neutral by Tom, Overweighted by Mark

Tactical Momentum Rankings

Momentum rankings remain mostly unchanged, with the biggest change being in the Technology sector – although the Technology sector is still highly ranked in quant, EPS, and trend models, its recent price weakness, driven by both the DeepSeek upheaval and weak earnings outlook, caused it to drop from #2 last month to #6.

Apart from Technology, Energy also deteriorated in tactical momentum rankings. Energy performed well following the year-end market risk-off after the December FOMC meeting. However, with the decline in crude oil prices, the energy sector gave up half of its gains since then. In our tactical momentum rankings, it fell from #5 last month to #8.

Other sector rankings remained largely unchanged. Financials joined last month’s Communication Services and Industrials as the top 3, so we tactically increased Financials weight by 2%. The bottom three remain Consumer Staples, Materials, and Real Estate. Although these three sectors have seen short-term price momentum improvement, they still rank poorly in our quant, EPS, and trend models.

Compared to last month, technology saw the largest weight decrease – this was due to both its overall weak relative performance in January and its decline in our tactical momentum rankings, as mentioned above.

Financials saw the largest weight increase, rising by 2.4% compared to last month, mainly due to its higher ranking in tactical momentum rankings. The strong earnings performance of banks also made Financials one of the best-performing sectors in January.

Healthcare, Industrials, and Communication Services saw weight increases of 0.4%, 0.3%, and 0.3%, respectively, due to strong relative performance.

Compared to the overall index, our largest overweight positions are in Financials, Industrials, and Communication Services, with an additional recommended weighting of 2.3%, 2.2%, and 1.9%, respectively.

Due to this month’s weight reduction in Technology, we are now only recommending an additional 0.7% weighting in Technology.

We recommend overweighting Consumer Discretionary slightly higher than the overall index by 0.4%.

We recommend market weight on Energy, Healthcare, and Utilities.

Currently, we recommend 0% allocation to Basic Materials and Real Estate. As for Consumer Staples, we recommend a reduced weighting of -4.1% compared to the index, the same as last month.

*The above-mentioned weights are based on an 85% Sector ETF + 15% Tactical ETF allocation. If you are 100% allocated to Sector ETFs, you can refer to slide 43 in the attached Deck.

ETF Picks

Since the release of the January Sector Allocation Report (1/7), all five sector picks have gained, with two outperforming the market and the other three slightly trailing. The five ETF picks have, on average, outperformed the S&P 500 by 0.9%.

For February, we continue to recommend CIBR -0.51%  and SKYY -1.11% . Within the technology sector, software remains our preferred segment over tech hardware and semiconductors.

We replace the other three ETFs ARKQ -1.59% , IWF -0.90% , and JETS -0.38%  with ARKW -1.79% , IAI -0.47% , and IEDI -0.21%  due to their strong technicals.

• We replaced ARKQ -1.59%  with ARKW -1.79% , mainly due to ARKQ’s recent weakness (caused by semiconductor exposure).

• Broker-dealers and the broader financial sector performed well in January due to strong earnings. This relative strength is likely to persist, so we added IAI -0.47%  to our February recommendations.

• The Q4 holiday season was strong, as evidenced by both strong GDP consumption components and Census Bureau Retail Sales. The IEDI Consumer ETF has also been strong, rising over 5% in the second half of January and retesting the prior peak seen in early December last year.

Updated Five ETF Picks:

• ARK Next Generation Internet ETF (ARKW -1.79% )
• First Trust Cloud Computing ETF (SKYY -1.11% )
• iShares U.S. Broker-Dealers & Securities Exchanges ETF (IAI -0.47% )
• First Trust NASDAQ Cybersecurity ETF (CIBR -0.51% )
• iShares U.S. Consumer Focused ETF (IEDI -0.21% )