2nd Quarter 2017 Market Update
A New Growth Stock Super-cycle Upon Us?
Market Review
The U.S. stock markets posted another solid quarter and are now up 9% year-to-date. Not bad considering all the warnings of future low returns that I keep reading about in the financial press.
International and emerging market indices continued to assert their relative strength over the U.S. markets during the 2nd quarter.
The S&P 500 is within 2% of its all-time high while international and emerging markets are rallying hard in 2017 to make up for lost ground.
Reminder, this is a Bull Market
- In August of 2016 I wrote that a bull market is here and our expectation was for a continued market rally based on strong technical's and momentum that is occurring across markets and sectors. Our analysis has been spot on. A bull market is occurring while many individuals continue to sit in disbelief of the rally. This has occurred since the 2008 bear market as many keep waiting for the next 40% drop.
Not your father’s P/E
A favorite saying amongst wall streeters is “It’s never different this time” which is usually a comeback to euphoric bulls who find obscure and different ways of valuing business to justify lofty prices while they scream “It’s different this time!” The most memorable of which harkens back to the tech heyday of 2000 when eyeballs were the data set used to justify the internet companies of the day.
So the saying “it’s never different this time” is usually correct, in most circumstances, unless of course, it truly is different this time.
This brings me to the P/E ratio. The ratio that’s been used since the buttonwood tree trading days of long ago and still employed by countless market veterans, and talking heads in financial entertainment. Fundamental types continue to rely on this, and possibly other old archaic data metrics that may have very little meaning in the current market.
Yes, I can already hear the groans of some that want to use that old Wall Street saying, “it’s never different” on me now. Old school valuation metrics such as price to earnings (P/E) were based on a totally different historical data set that currently might not represent the global macro market.
The question is, should one use a historical average P/E multiple and apply in an environment characterized by global central bank intervention and continuous artificial low-interest rates? I would argue no. The developed world has changed significantly in the past 10 years (artificial means) and for these reasons, one can argue that the market has adjusted and now will trade at a higher P/E ratio than before. Let’s examine some facts.
Birth rates in developed countries are declining for the first time in history.
Debt levels remain high and will remain high inside low growth world.
Inflation not really moving higher despite massive central bank intervention.
Low level of global growth.
By the way, the above are bullet points are reasons why global central banks are in a box.
Other facts:
Japan continues to buy assets including ETF’s to fight deflation.
Chinese government spends a hefty portion on the private sector to keep growth alive.
Europe has picked up the QE baton from the US.
The economy is rapidly changing.
Productivity due to technology gains proliferate.
Millennials rapidly altering the economy and disrupting old business models.
Global economies continue to improve and grow…slowly.
Famed value investor Jeremey Grantham recently opined that the higher P/E ratio that has been in place since about 1996 is due to several reasons, first he cites the degree of margins and corporate profitability that have existed among public American companies since that time and the second being the low-interest rate environment since 1996, which has led to increased leverage.
(Source: http://www.institutionalinvestor.com/article/3714159/investors-pensions/gmos-grantham-brace-for-continued-higher-prices.html#.WQzAJXyuXo)
The point here is to keep an open mind that things may be truly different this time. The markets may be adequately valued, or even gasp, under-valued, not over-valued as some are making us believe. This is true, unless of course we are referring to value oriented stocks who’s single digit annual growth rates have them currently trading at or above a market P/E ratio. For these stocks, the risk may not be worth the reward.
As I will discuss later, there may be room for this bull to run longer if the “e” (earnings) portion of the P/E continues to climb, which is the case in a few of our favorite sectors.
But, But… it’s just the FANG stocks! …No, not really
One misconception making the rounds on financial entertainment TV and amongst underperforming stock managers is the only stocks going up are the FANG stocks. These stocks are Facebook, Apple (or Amazon), Netflix (or Nvidia) & Google. Let me put this to rest and tell you this is not the case. The current rally is broad and deep if you know where to look for it.
We track around 250 stocks for analysis and inclusion in the Risk Managed RS Leaders stock model. This a filtered universe of stocks exhibiting high earnings growth along with other positive growth metrics. Out of the 250, the following is noticed:
178 of the 250 or 70% have positive returns trailing 1 year. The median return of these is 24% the past 52 weeks!
165 of the 250 have positive returns year to date with the average return being 23% and median return being 18%. That’s 65% beating the S&P 500 by a good margin.
200 of the 250 are ranked higher than the S&P 500 using our Volatility Adjusted Relative Strength Metric.
The median market cap of these companies is 7 billion. See where I am going with this? (Hint- see RS Leaders write up later in this review).
Advisors Blind Spot to Growth Stocks:
This is a very exciting time to be a growth investor. The world is rapidly changing, industries are being disrupted, but many of you have not adapted your client’s investments to take advantage of it. Most advisors we talk with have their clients loaded with the stuff that worked in the last cycle, namely value and dividend plays. This made a lot of sense in a declining, zero-interest rate world. While interest rates will likely remain low(er) for some time, the change in interest rates is up, though slowly. This is enough to get institutions hedging and re-balancing into growth.
For the past 3 months, large institutions have been rotating out of the yield play and into earnings winners. These have mostly been found in the mid cap growth space and we now are seeing signs of it moving into small cap growth. The reason for this is easy, growth stocks lead when interest rates rise.
The chart below shows the recent periods when Fed Fund rates were rising and how different categories performed during those periods. The best was the Russell 1000 Growth, Russell Mid Growth, and Russell Small Growth. The worst? The Top 20% of dividend payers.
So where are these exciting things happening?
The millennial's are changing the way we live and it’s happening fast. Millennial's love a few things:
Their video games
The rental economy
Not getting off the couch to order stuff
Choosing experiences over stuff
You see this playing out in the stocks market every day. Stocks like Amazon, Netflix, Electronic Arts and even in the leisure stocks such as Marriott and Vail Resorts.
It’s just not the millennials that are changing the economy but the baby boomers are as well. It’s no secret that as the baby boomers age they are spending their money on re-tooling their aging bodies using medical technology and on experiences and pricey stuff i.e. cars, boats, RV’s. These themes are playing out stocks like RV maker Thorium, Winnebago as well as auto maker Ferrari. Currently, the medical device sector is hot, and probably my favorite sector for the next few years. The advancements being made are pretty incredible. From robotic surgery to cures for diseases, this industry has a secular tailwind behind it.
It’s our experience that advisors have very little exposure to growth, especially in the mid and small cap space. The risk you face as advisors, and ultimately the clients, is not having exposure to these areas of the market. J2 Risk Managed RS Leaders is currently positioned and poised for this continuing trend.