SKYY ETF: Long-Term Prospects Unchanged, But Wait For A Better Entry Point

Investment Thesis

In my last article on the First Trust Cloud Computing ETF (NASDAQ:SKYY), I discussed how the fund was attractively valued and how potential dips were buying opportunities. Since then, SKYY has lost ~25% vs. a loss of ~12% for the S&P 500 and has underperformed the market. While the long-term growth story of the cloud category is still intact, I believe volatility will be high in the short term. We now have the confirmation that the Fed is moving ahead with quantitative tightening, which clearly had a negative impact on tech stocks. On top of that, the prospects of a recession have spooked markets in recent weeks. I personally believe a recession is a highly probable scenario at the moment. As a result, patient investors will be rewarded with an opportunity to buy shares at a cheaper price in the next couple of months.

What Has Happened Since My Last Article

As a reminder, First Trust Cloud Computing ETF tracks the performance of the ISE CTA Cloud Computing Index, which is composed of companies involved in the cloud computing industry. You will find below a recent breakdown of the top 10 holdings, and you can read more about the strategy in my previous article.

I have compared below SKYY’s price performance against the Invesco QQQ ETF (QQQ) over the last 4 months to assess which one was a better investment. Since my previous article, SKYY underperformed the Nasdaq 100 by a ~9 percentage points margin.

The cloud market in general had a difficult start to the year. These terrible returns are not exclusively impacting SKYY shareholders, but also other cloud strategies. Cloud stocks have underperformed the NASDAQ 100 YTD, regardless of the index you are following.

As a result, SKYY has noticed first-hand the effects of capital outflows. Investors pulled nearly $174.24 million since late January 2022 out of the fund. Investors’ interest is now shifting from growth and tech stocks to inflation and geopolitical risks. Recently, recession topped several surveys as the new main concern over the next 12 months, which means market participants are slowly shifting their focus to consumer defensive stocks in an effort to protect their wealth.

What’s Next For Cloud Stocks?

In 2021, tech startups raised $628 billion, roughly double the 2020 amount. Nevertheless, private equity dealmaking has slowed in 2022, putting downward pressure on current market valuations.

The latest results for publicly traded cloud service providers were robust, indicating strong demand. In the most recent quarter, Microsoft’s (MSFT) cloud division boosted sales by nearly 32% YoY to $23.4 billion. Alphabet (GOOG) (GOOGL) also had a nice run, growing its cloud revenues by 44%.

Yet, multiples paid for publicly-listed cloud stocks are far from being in bargain territory, and SKYY is no exception. The fund has a P/E ratio of ~21.5, which is similar to what you would get on a plain vanilla NASDAQ 100 ETF, but lower when compared to other Cloud ETFs such as the WisdomTree Cloud Computing ETF (WCLD). Given how high inflation is and the uncertainty surrounding the current hiking cycle, I personally believe valuations across this sector can go lower.

10-year yields are now close to 3%, which means there is a new alternative competing with equities. A PE of 22 still offers a better deal than a 3% yield, but it is hard to predict the course of this hiking cycle, as everything will boil down to how sticky inflation will be.

Interest rates work like gravity on stocks, especially on securities trading at lofty valuations. While it isn’t necessarily the case for SKYY, the US tech sector is still expensive based on how high inflation is. Considering the fact that Technology represents over 80% of SKYY’s total assets, I believe the fund has a chance of underperforming the market as seen in recent months in the short term.

Another risk investors are facing at the moment is the higher probability of a recession over the next 12 months. Consumer sentiment in the US continues to deteriorate, reaching levels last seen in 2008. These figures come as the economy remains strong in theory, house prices are rising, and unemployment is low. Any changes in these parameters could exacerbate the decline in consumer sentiment over the next few months, ultimately leading to demand destruction.

I think it is important to keep in mind these changes happen while volatility is still far from its 2009 and 2020 peaks. I would therefore expect volatility to be a constant feature for many constituents over the next couple of months. In my opinion, this must be seen as a good thing, a buying opportunity for patient investors willing to deploy capital opportunistically. Since volatility clearly has more room to increase, I believe the bottom is nowhere near and SKYY faces further downside risk.

Key Takeaways

While the long-term picture is still intact for cloud stocks, I believe the current macro environment has reshuffled some of the priorities for many investors. Rising rates coupled with the risk of a potential recession made investors more aware of the dangers of holding expensive stocks. As a result, I expect volatility to be high in the coming months, which should be seen as an opportunity for patient investors to accumulate shares at a cheaper price. At the same time, I believe investors are in no rush to buy the dips, as I don’t expect to see a bottom in SKYY over the next couple of weeks.