Quarterly Market Update
Risk On Rotation Likely to Favor Small-Cap Stocks
Continuing moderate growth and a quiet fourth quarter could result in low double digit returns by year end.
The third-quarter market delivered a few nice surprises just when few expected it. Headed into July, following on the heels of the U.K.’s surprising vote to leave the European Union and the Fed’s subsequent decision to leave interest rates unchanged, pundits projected a weak third quarter whipsawed by volatility associated with political and policy uncertainty. But what investors actually received was a great deal of sideways action that culminated in a modest appreciation in U.S. stock markets and more respectable international returns than we might have anticipated. Nice surprises aside, the quarter was a somewhat curious one as a number of precepts surrounding historical relationships and correlations were tested.
U.S. household income surged 5.2% in 2015, the first increase in eight years, a tad shy of where incomes were before the recession began. Given the surprising income gains and respectable jobs numbers, one might expect that at some point the data will bleed over into the economy, but so far it has not. Perhaps consumers are saving, paying down debt, or spending the extra income on healthcare premiums. The U.S. Household Saving Rate continued to rise from the record low of 1.90% in July 2005 to 5.70% in August, the most recent period available, so it would appear that consumers are still repairing their balance sheets. We anticipate that at some point consumer spending will tick back up, but it did not happen this quarter. Nor did consumers put their surplus funds into the stock market – flows into equities remained negative.
The economic data in some areas appears, if not skewed, then certainly far from a bell curve. For example, while headlines tout the strength in the housing market, it is actually very robust only within a narrow context, primarily where a certain segment is buying and selling homes. There is limited inventory available, and turnover is anemic. Many homeowners are choosing to stay in their homes which has impacted the trend of downsizing or trading up that helps fuel expansion. Consequently, it would be misleading to characterize the housing market recovery as a broad one.
Although inflation ticked up mildly in July, the level of competition competition calls into question the level of actual deflationary pressure. Competition- driven commoditization as consumers increasingly cut the cord in favor of subscription streaming services like Netflix is driving down some cell phone and cable bills. And, in certain cities, the price of groceries has also come down.
Performance Rotation Appears Underway
Small-cap and emerging market stocks were the two best performing asset classes. Early on the market favored large-cap value stocks, but the rotation has now swung more to growth stocks. Typically, when investors anticipate sluggish economic growth, they tend to favor Steady-Eddie earners over more cyclical companies in sectors like consumer discretionary. The rotation could be a result of profit taking as the defensive sectors have outperformed this year, but then again, it could auger a stronger economy going forward.
Year-to-date, more defensive sectors like telecom and utilities are the best performing sectors; telecommunications and utilities sectors were both up over 20%. The outperformance has been driven by the reach for yield by investors who cannot traditionally afford the heightened level of risk that is now possible in what was once considered the “widows and orphans’” area of the marketplace. Historically, these stocks paid a nice dividend but did not provide much price appreciation. That changed in 2016 as the defensive sectors experienced significant price appreciation following extraordinary flows fueled by investors looking for yield. As a result, the valuations of these stocks have been stretched relative to other areas of the market.
The performance of information technology stocks improved as investors continued to buy companies like Google, Facebook, and even Apple. Apple was down almost 10% for the year and then up 19% in the third quarter. The poor performance of consumer discretionary stocks was a bit baffling. Despite an uptick in consumer confidence and respectable growth in the jobs market, retail sales were down. Some pundits believe retail sales are being held back by the election, although the election does not appear to be negatively impacting confidence.
Earnings Continue to Disappoint
Valuations remain a bit high, and after what could now be six consecutive quarters of year-over-year declines, earnings need to materialize in order to rationalize these levels. According to FactSet, as of September 23, 2016, the forward 12-month P/E ratio for the S&P 500 is 16.80%, above both the five- and ten-year average.
For the third quarter, the estimated earnings decline for the S&P 500 is -2.30%. Earnings growth is not expected to return until the fourth quarter, when the estimated growth rate is 5.70%. For all of 2016, analysts are projecting earnings to decline year-over-year by -0.30%. The price of oil is a key driver for S&P 500 companies. Now that OPEC is at least discussing its first production cut in eight years, it could pave the way, when combined with a more stable U.S. dollar, for future earnings growth.
That said, considering current interest rate levels, valuations are not as stretched as many contend. The question is what happens if rates tick up or global growth slows. We are frozen in a narrow channel where the investor is frightened of what is to the left and what is to the right, seemingly comfortable only if we continue to muddle along straight ahead. We see this time and time again when the Fed signals that while growth is good, it is not yet robust enough to raise rates. Each time the market rallies. Apparently there is reassurance in clutching at low rates and modest growth because the combination staves off market volatility and a possible correction. But eventually we must have stronger growth, even if the price is heightened volatility, because growth is required to produce the earnings necessary to rationalize current valuations.
We anticipate a tempering of defensive stock performance as profit taking commences, but we remain in a risk on rotation which favors small-cap stocks. If the economy continues to chug along at the current pace, and barring a sudden left-field headwind, the S&P 500 could very possibly end the year up low double-digits. No one anticipated such a conclusion to a year that experienced what was described as the worst 10-day beginning ever as oil prices struggled to find a bottom, and the world worried about how the economic slowdown in China would impact global growth.
We anticipate that as we move closer to a rate hike, more money will likely flow out of dividend payers and into small-cap stocks and emerging markets. We anticipate a tempering of defensive stock performance as the profit taking commences, but we remain in a “risk-on” rotation which favors small cap stocks.
The impact of the election cycle is likely negligible in the long term. Typically, in an election year, markets experience greater volatility in the first half of the year which mitigates in the second half. But this year, the concern has been that the greater volatility in the first half may not let up due to such a contentious presidential election.
We continue to be cautious in international stocks. While the Brexit has not been the fire storm that everyone anticipated, just because it did not have an impact on Day 1 does not by any means preclude future disruptions. The U.K. has not yet formally requested that the two-year decoupling process commence. We believe the transition will not only pressure U.K. earnings and economic outlook, but also further test the stability of the European Union itself.
We prefer emerging markets to international developed. So much of the decision is currency driven. If the U.S. dollar does not appreciate – and that is a long shot given that the Fed remains poised to increase rates – then international investing would not be as concerning. But certainly as long as the economy remains in the current “Goldilocks” environment, not too strong and not too weak, and the greenback does not appreciate dramatically, then emerging markets are attractive because these countries have successfully wrung out many of their excesses. That said, emerging market stocks are so volatile, no matter how attractive, we are limited in how much we can allocate to the category.
In conclusion, we want to emphasize the difference between the valuations of a market being high versus the valuation of a specific company being high. Not all companies are expensive right now. We are finding opportunities in consumer discretionary, financials, and other areas that have not participated in this year’s rally. These companies are relatively cheap because their short-term outlook has been dampened by weak consumer spending, and in the case of financials, because the Fed has held rates low. It will not take a large trigger to light a fire under these stocks. If the Fed raises interest rates by 25 basis points, financials will jump; if retail sales perk up a bit, consumer discretionary stocks should jump. Their attractiveness lies in the fact that these are not terribly expensive, and they are certainly more fairly valued relative to defensive stocks.
It is also important to note the distinction between dividend-paying companies and companies that are dividend growers. The sweet spot is in stocks with a 2.50 to 4.00% dividend yield and a consistent track record of growing that dividend stream. We continue to look for, and find, these stocks.
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Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).