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Dec 04 2020

Research Preview: Rotating Away From Growth

  • Dec 4, 2020

This study examines Value, Small Cap, and Emerging Markets to see if they do, in fact, behave in a correlated manner when viewed as alternatives to Large Growth. The goal is to determine whether this trio of rotational favorites can be considered as broadly-equivalent replacements for LG.

The 2020 post-election stock surge looks and feels a lot like the 2016 “Trump Bump.” But, of course there’s a spoiler. The Biden Bump started with a Normalized P/E level about 30% higher than the one prevailing on election eve of 2016 (26.8x versus 20.5x, respectively). 

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Many pundits argue that sky-high valuations on stay-at-home stocks “prove” equity investors somehow remain fearful. It’s a nuanced, short-term argument, and there’s merit to it: We’d argue such fears have produced terrific relative values among “SMID” Cap stocks. 

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The “Biden Bump” brushed away any lingering technical deficiencies in the stock market, but that happy state of affairs is reflected in extremely frothy-looking short-term sentiment indictors. We are riding the momentum to some extent, but with a lower base-level of exposure.

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We studied several “popular trades” and there are good reasons to be on board with most of them, but none can be viewed as a no-brainer.

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The November 9th Pfizer vaccine news compressed an entire Momentum reversal into one historic day. Factor performance easily broke records looking back over our entire history of data. While great news for the general public, it was awful news for Momentum indicators.

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We review relative price-action patterns among industry groups belonging to the “reopening economy” theme. These are areas that have been hit hard by the pandemic and should benefit the most from a return to economic normalcy. Conversely, a variety of industries profit on days when it appears that the economic shutdown may be prolonged. Recent performance is incorporated to re-examine the trends.

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While quant managers watched their factors failing one by one, and market bears stared at the tape in disbelief, the number of retail investors continued to multiply and we witnessed a dramatic performance advantage for low quality stocks. Are we entering a prolonged “junk-rally” cycle? 

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Large cap stocks’ equal-weighted price index has persistently trailed the market-cap-weighted return during the last four years. Over the past 100 years, only a handful of similar moves has rivaled the magnitude of this underperformance. More importantly, beginning in September 2020, the equal-weighted index has demonstrated a Rare Reversal.

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Read this week's Major Trend. 

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Balanced portfolio investors face a difficult challenge finding equity alternatives that modify risk without overly reducing reward. The problem is acute because traditional choices have lost much of their historic appeal. Cash certainly lessens volatility, but, with a zero yield, its reward penalty is excessive.

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The Dow Jones Transportation Average has recently notched fresh all-time highs. Following a sizable relative performance dip earlier in the year, the Transports’ relative strength has recovered and moved to new 2020 highs (Chart 1).  Still, compared to the broad market, the index’s YTD return appears fairly unremarkable, outpacing the S&P 500 by about 3%.

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Perusing current equity-investment possibilities highlights a diverse set of choices. Focusing on only two primary attributes—relative price and relative earnings—illustrates considerable diversity among the major investment styles.

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Read this week's Major Trend. 

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Consumer Price Inflation of 1.2% for the twelve months through October remains way below the Fed’s long-time 2% objective, which is nothing new. But a first step in getting inflation to eventually run a little bit “hot” (the Fed’s new objective) is to break the long-term disinflationary psychology among consumers and investors, and that is clearly happening. In fact, based on the excellent “Inflation Surprise” Indexes published monthly by Citi, the U.S. is now the world’s inflationary hotspot!

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Although COVID-19 has significantly impacted everyone, its economic wake has been unusually bifurcated compared to past crises. Since the pandemic requires social distancing, the recession and its aftermath have been concentrated disproportionately among “social and lower-earning” industries. This odd, if not unique, divergence in the economic fortunes of low and high-earning industries perhaps explains how overall real GDP, the unemployment rate, the housing industry, manufacturing activities, and other economic segments have managed to recover quickly and powerfully.

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Read this week's Major Trend.

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Dividends are a cornerstone of equity investing and over the decades they have produced a significant portion of the stock market’s total return.  Previous Leuthold research has identified a strong dividend influence on total returns for small and midcap companies.  Looking at S&P 500 constituents, we see that dividend growers outperformed companies that had flat or declining dividends – an expected outcome.  However, we also found that companies not paying dividends convincingly outpaced dividend payers.  This is contrary to the results in other market segments, but the explanation for this becomes apparent in the course of our research.

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In Minnesota, we’ve lived through a lot of COLD Winters! Could we now be headed for another doozy? The clocks have already been turned back, shrinking the daylight as the sun comes up later and sets earlier. Old Man Winter has wasted no time bringing record cold temperatures in October and snow cover, reminiscent of January, here in early November.  

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If Momentum and Growth investors thought they were escaping 2020 unscathed, they learned otherwise on Monday. Pfizer’s promising news about a COVID-19 vaccine was met with universal excitement and investors rearranging portfolios—taking gains in long-term winners and plowing into beaten-down cyclical stocks. 

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The CPI numbers are slightly below expectations. Positive vaccine news has kept the rotation trade alive. Our moderate inflation view is supported by the latest reading of Inflation Scorecard.

 

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The frightening COVID-19 winter-wave has understandably intensified calls for additional action both by monetary and fiscal authorities. Indeed, if widespread lock-downs are again implemented, the economy will need another bridge of support.

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Read this week's Major Trend.

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Since 2006, the value investment style has suffered its deepest and most prolonged period of underperformance of the entire post-war era. According to the total U.S. stock database from Kenneth R. French, during this nearly 14-year period, value has underperformed growth by an astounding 58% (4.3% per annum)!

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With no new stimulus package and a resurgence of COVID cases, worries surrounding the economy’s durability remain widespread. While this morning’s job report certainly helped quell some of those fears, there is actually a broadening array of economic gauges portraying an expansion that is becoming self-sustaining with or without additional stimulus.

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On the basis of both Normalized P/E and Price/Book, there’s plenty of runway for EM stocks if they get back to even the midpoint of their 20-year valuation range. Rising commodity prices and a weak dollar would obviously help, and we expect both in the year ahead.

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Diversified, multi-asset portfolios have been weak performers for many years. The ultra-flexible, macro hedge-fund manager represents one extreme of the asset allocation continuum. At the other extreme would be the passive holder of multiple asset classes. It’s been a tough three years for this breed, too.

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If there’s an emerging bubble in Growth stock investing, it certainly doesn’t apply to Small Caps. The “usual” premium for Growth over Value within the Small Cap space is nonexistent—both segments look historically cheap.

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There are numerous ways to measure sector valuation, but we found the simplest one: sector weights. Overall, using simple sector weights, we arrive at the same conclusions about sector valuation as one would using conventional valuation metrics.

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We crunch some numbers to see how 2020’s stock market trends have fared compared to the typical election year, and we slice and dice past post-election year trends at the sector and industry group levels to look at potential opportunities in the coming year.

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Last month, we briefly discussed a burgeoning investment vehicle—Special Purpose Acquisition Companies (SPACs), also known as “blank-check companies.” Since the sole purpose of a blank-check company is to find an operating business to merge with, and subsequently bring it public, the best method to gain some understanding about the outcome of these relationships is to look at past deals.

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Dividends are a cornerstone of equity investing and, over the decades, they have produced a significant portion of the stock market’s total return. Previous Leuthold research has identified a strong dividend influence on total returns for small and mid-caps; a client recently asked if we found the same effect in the universe of S&P 500 companies. Specifically, have S&P 500 dividend-payers outperformed non-payers, and, second, have dividend growers outperformed non-growers?

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Read this week's Major Trend. 

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There is plenty to worry about of late. A record-setting wave of new COVID cases is threatening to curtail economic activities. If a “COVID Winter” overwhelms U.S. hospitals—leading to widespread lock-downs—economic growth could be significantly impacted. FAANG stocks are under pressure, sending the stock market to the low end of a three-month trading range.

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Which box do you check? The “status quo” or the “change of pace?” Keep in mind, the same decision in front of you turned out to be extraordinarily important four years ago. So, which will it be for 2020 and beyond? Large Cap Growth or Small Cap Value?

 

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Everyone is understandably concerned about the recent surge in COVID-19 cases. Outbreaks in the U.S. have risen to the highest level since the pandemic arrived. Now a primary concern for investors is, will it significantly slow momentum in the economic recovery?

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Trendline analysis is a useful tool for assessing valuation risk and upside potential within the stock market. Unlike conventional valuation tools, it does not directly compare the stock market level to its fundamentals. Rather, it appraises performance relative to time, which indirectly relates price to fundamentals. Why? As Warren Buffet regularly points out, “stocks rise in the long run” because, with a very high probability, economies grow.

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As we Chinese watch the elegant display of the western democratic process this election season, we can’t help but think there are indeed people less fortunate than us “commies.” Worse yet, some of these people are Value investors.

 

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Governmental powers are still trying to put together another economic relief package. However, despite the July expiration of unemployment benefits provided by the CARES Act, here, two-and-a-half months later, U.S. economic momentum is remarkably healthy.

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According to FactSet estimates, S&P 500 earnings for 2020 are anticipated to come in near $133 per share, a drop of 18% from 2019 results. Given the widespread business disruptions and closures caused by the pandemic, one might have expected this year’s results to be much weaker.

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