A Change In Equity Market Leadership Is A Positive

One favorable aspect of the current equity market is the broader favorable performance across a wider range of asset classes and investment styles. I wrote about this in mid September last year and at the time raised the question whether this rotation or change in leadership had more room to run. The below chart clearly shows that a shift in leadership has carried through the first quarter of this year. The blue line on the chart represents the average total return of the six stocks, Facebook (FB), Amazon (AMZN), Netflix (NFLX), Google (GOOGL), Microsoft (MSFT) and Apple (AAPL). Collectively, these six stocks are trailing in performance relative to the other asset classes shown. Up until September though, the asset class returns were essentially reversed as seen in the second chart.

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A Policy Error Could Trip Up Stocks

Broadly investors have enjoyed strong returns in stocks over the past two years, the S&P 500 Index returned 31.5% in 2019 and 18.4% in 2020. Last year's return occurred in an environment where earnings for S&P 500 companies is expected to equal $133, down from $157 in 2019. This move higher in stocks at the same time earnings declined has pushed large company stock valuations to levels where one might say they are priced for perfection. One way to look at stock valuations is reviewing a measure called the Rule of 20 which states that stocks are fairly valued when the inflation rate plus the price earnings ratio of the S&P 500 Index equals 20. As the below chart shows this measure currently equals 23.4. If one uses the P/E based on the index's 2022 earnings, the measure equals approximately 20.4.

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Broadening Participation In Equity Market Asset Classes

One favorable aspect of the recent equity market performance is the broadening participation of asset classes other than the large cap FANGMA stocks, Facebook (FB), Amazon (AMZN), Netflix (NFLX), Google (GOOGL), Microsoft (MSFT) and Apple (AAPL). As the below chart shows, during the first eight months of 2020, the average return of this basket of stocks significantly outpaced the other asset classes shown on the chart.

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The Tide Might Be Going Out On Growth

The dominant investment theme since the financial crisis in 2008/2009 has been the outperformance of the growth investment style versus the value style, evident in the large, mid and small cap stock space. As the below chart shows, growth has dominated value in large caps since 2008 and has accelerated higher this year.

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Mega Cap Stocks Run Into A Headwind

The first two days of September saw the S&P 500 Index get off to a nice positive start, up 2.29% on a price only basis. Since then though the market has declined 5.4% on a total return basis. This decline has been led by the large cap technology stocks in the index. The blue line in the below chart represents the average return of six large cap technology companies in the index, Facebook (FB), Amazon (AMZN), Apple (AAPL) Netflix (NFLX), Alphabet f/k/a Google (GOOGL) and Microsoft (MSFT).

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Elevated Asset Level In Money Market Funds

I have noted in recent blog articles the fact investment flows into ETFs and equity mutual funds has been strongly negative, i.e., outflows. Some of the equity outflows have found their way into fixed income ETFs and mutual funds. Another large beneficiary though has been money market funds. The below chart shows assets in money market mutual funds as reported by ICI as of mid week last week. Money market assets began to trend higher during the volatile market environment in 2018 and the money market inflow has picked up the pace in 2019 with assets now totaling $3.49 trillion.

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Tactical Asset Allocation Can Add Value To Portfolio Return

A potential downside for investors employing a strict longer term strategic investment allocation based on a specific benchmark or index is that the strategy fails to incorporate shorter term tactical changes. It certainly can go without saying but indexing strategies are popular ones for investors. In fact we utilize some index products in our investment approach with our clients. The downside for investors is many investment approaches may only utilize an index approach and construct an investment portfolio based on a longer term strategic asset allocation. In other words, a benchmark is selected and the client portfolio is allocated or invested in the same weightings that comprise that benchmark.

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The FAANG Trade In Focus Again

Since the equity market peak in the third quarter of 2018, the average return of the FAANG basket of stocks, i.e., Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX) and Alphabet f/k/a Google (GOOGL), has underperformed the broader S&P 500 Index as seen below. I have highlighted the significant contribution the FAANG's have had to overall market returns in prior posts like the Growth verses Value article in 2017.  With the FAANG's return to the upside since the start of this year, the basket has resumed its outperformance and broken out of an inverse head and shoulders chart pattern (h/t: The Kirk Report).

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Cyclical Stocks Outperforming Defensive Stocks An Indication Of A Strengthening Economy?

Since the beginning of 2018, investors have encountered a stock market that is more volatile, yet at a level of volatility that is more normal. The below chart shows the return pattern for the S&P 500 Index since 1/2/2018 and the steep decline that began at the end of last September has been followed by a sharp recovery in 2019.

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Increasing Bullish Equity Sentiment And Declining Bond Prices

As of Wednesday's market close, the S&P 500 Index is up 11% on a year to date basis, while most bond strategies have struggled to breakeven at best. Longer term bonds have been the most challenged as evidenced in the below chart. The iShares 20+ year Treasury Bond ETF (TLT) is down 7.7% year to date. Through Wednesday's close, the 30-year U.S. Treasury is down 11.1% year to date. Of course, as interest rates rise, longer term bonds tend to be the least favorable bond investment as prices move inversely to the move in bond yields.

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A Strategy Based On Stock Buybacks Continues To Underperform

It seems one key focus of recent commentary has been the buyback activity by companies due to the cash flow benefit resulting from the tax cuts passed late last year.

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If Earnings Matter, Equity Valuation Looks Attractive

With last week's final reading on first quarter GDP, the Bureau of Economic Analysis provides a final review of the National Income and Product Accounts (NIPA). One category worth evaluating is the corporate profits figures. Corporate profits from the NIPA tables are true economic profits from IRS data and not simply profits based on GAAP. In the final GDP report last week, corporate profits with IVA & CCAdj totaled $1.92 trillion at a seasonally adjusted annual rate versus $1.64 trillion in the same period a year earlier. This represents a nearly 17% increase in profits from a year earlier.

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Potential For A Stronger Second Half In Stocks

Seems as though much has taken place in the first five months of this year that is newsworthy and impactful to the markets, i.e. Iran, North Korea, tariffs, an increasing 10-year yield, and I could go on. With the volume of news flow though, the equity market has essentially traded sideways this year with the S&P 500 Index price return equaling just 1.78%.

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Dollar Strength Leads To Large Cap Stock Outperformance

A recent strengthening of the US Dollar has some investment commentary now favoring small cap stocks over large cap stocks. This is partly due to the earnings headwind that can negatively impact multinational companies as they convert foreign earnings back into the Dollar. One recent report titled, Rising Treasury Yields And Dollar Completely Change Investment Themes, noted:

"The resumption of the bull market has taken shape in the form of small caps. I fully expect that the rest of the market will follow suit eventually, but rising treasury yields and the surging dollar have money rotating feverishly into smaller companies and that relative strength is likely to continue."

In the below chart, a downward trending red line indicates small cap stocks are outperforming large cap ones. In 2018 small cap stocks have outperformed large cap stocks while the US Dollar Index (DXY) has risen from below 90 to almost 94.

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Heightened Volatility A Result Of The Change In The Earnings Growth Rate

Investors are experiencing a market exhibiting a higher level of volatility. This heightened volatility is more normal than the lack of volatility experienced in the few years leading up to 2018 and yet the S&P 500 Index is down less than 2% this year.

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Dividend And Stock Buyback Growth Potentially Accelerate In 2018

Near the end of last month S&P Dow Jones Indices reported preliminary dividend and buyback activity for the S&P 500 Index for the fourth quarter of last year. For the quarter the dollar amount of dividends paid increased 5.4% versus the same quarter in the prior year. Additionally, for the quarter, dividends combined with buybacks increased 3.1% year over year. It is not uncommon for the combined dividends with buybacks to exceed as reported earnings in the quarter and that was the case for Q4 2017 as seen in the below chart.

Source: S&P Dow Jones Indices

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Continuing To Favor U.S. Large Cap Stocks Over U.S. Small Cap Stocks

With the passage of tax reform, one market segment one might believe experiences an outsized benefit to earnings is U.S small cap stocks. This certainly seems plausible due to the fact smaller companies tend to have less direct exposure to foreign revenue; therefore, likely generating most of their profits in the U.S.

Our firm exited completely the U.S. small cap space in late 2013 based on a number of factors, with one being the relative valuation of small cap stocks versus large cap stocks. Reviewing the relative valuation of small caps versus large caps based on price earnings ratios has certainly turned to favor small over large as can be seen in the chart below.

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High Beta Stock Outperformance Suggests A Strengthening Economy

For the first part of 2017 low volatility equities were outperforming their high beta counterparts. However, as tax reform talk began to look more a reality in late August, high beta stocks resumed their outperformance that really began in early 2016. As the maroon line in the below chart shows, this high beta outperformance is carrying over into the beginning of 2018.

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Strong Corporate Profit Picture A Key Component In Today's GDP Report

Included with today's second estimate GDP report by the Bureau of Economic Analysis is the preliminary estimate for third quarter corporate profits. The corporate profit measure is reported in several different formats, i.e. with and without inventory valuation and capital consumption adjustments. As I noted in a June post, more information on the adjustments can be found can be found in this BEA Briefing Paper (PDF).

The profit growth before tax and with the inventory valuation and capital consumption adjustments equaled 5.4% on a year over year basis. Without the adjustments, year over year profit growth equaled 10%. Importantly, NIPA profits have a nearly 1.0 correlation to IBES S&P 500 forward earnings and historically peak four quarters, or a year before the IBES forward earnings estimate. This preliminary corporate profit report is not signalling a peak in IBES S&P 500 forward earnings.

Also, with the preliminary corporate profit growth figure one can evaluate the NIPA P/E. The growth in NIPA corporate profits has resulted in a slight decline in the NIPA P/E as can be seen in the below chart. As I noted in the June post referenced above, what is useful with the NIPA profit measure is the fact it covers a larger earnings base for the U.S and covers more industries as it is not limited to public companies. Additionally, the NIPA figure makes an effort to adjust for the differing accounting measures being utilized by companies.

By reviewing some of my posts written over the past few months, the lack of any meaningful market pullback has been one recurring theme. However, with the continued strength exhibited in corporate profit growth, the market's path is certainly warranted as stock prices follow earnings. Also, the strong profit picture is beginning to result in a downtrend in the market's NIPA valuation, without a significant correction taking place. That does not mean high valuation equities will not correct more significantly, like what occurred in some technology stocks today. All in all, today's revision higher in Q3 GDP and the prelimnary profit report are both tailwinds for the economy and equity markets, all else being equal.

Stocks Need Some Healthy Competition

It seems a day does not go by where various strategists lament the market's valuation and lack of any significant pullback in over a year and a half. Not only are the valuations of a number of equity indices above their long term average, some might say the valuations are indicative of the speculative froth in the market. One data point highlighted is the margin debt level. Certainly margin debt has increased as can be seen in the first chart below. However, the second chart shows that margin debt as a percentage of total equity market capitalization has remained fairly stable since 2010. A good article on evaluating margin debt can be found in a MarketWatch article from a few years back, Cash vs. margin debt is the real problem for this market.

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