Positive factors for stocks such as rising corporate profits are a counterbalance to concern over inflation.
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An unusual pattern is emerging in stocks, and it isn’t encouraging. While the market has moved up, growth stocks have fallen or failed to keep up.
That doesn’t happen in the early stages of a bull market, when high-growth stocks lead the way. It is more characteristic of the fading phase as leadership shifts from speculative growth to value stocks and safer blue chips. Indeed, the rotation out of growth lately has some uncomfortable parallels to market peaks in 1929, 1972, and 2000, all of which preceded brutal bear markets.
“It could be the sign that the market is going to turn lower in a broad fashion,” says Ben Inker, head of asset allocation at GMO, a value manager with more than $60 billion under management.
Granted, for all the negatives hitting stocks—led by fear of inflation and tighter monetary policy—there are some positives. Corporate profits are coming in ahead of Wall Street forecasts as the economy gains momentum, expanding at its fastest pace in decades. As the pandemic winds down and hiring picks up, profit estimates may even increase.
But plenty of market signals are flashing red. Cryptocurrencies, special-purpose acquisition companies, and tech stocks are ailing. Equity issuance has soared to its highest levels since the dot-com bubble. Investors have flooded into option bets on individual stocks. And the meme-stock frenzy earlier this spring was a warning that excess liquidity is sloshing around. That money may be starting to drain out faster than it rushed in.
With valuations looking steep, investors may have to temper their expectations for equity returns. Inker, for one, expects 3% returns, adjusted for inflation, in blue chips like Microsoft (ticker: MSFT), Johnson & Johnson (JNJ), and Apple (AAPL). That would be below the historic 6% real return in stocks. But it beats the yields in investment-grade bonds, and it may be all investors can reasonably expect at this juncture.
Another place to look is the value universe. While nothing is cheap on an absolute basis, Inker says value still looks more attractive than growth. Value normally trades at 50% of the valuation of growth, but it is now at 33%, up from 28% last fall. To go from the current valuation back to normal, Inker says, would imply value “winning” by 64% relative to growth.
“We think value stocks have plenty of room to run relative to the market,” he says.
Within the value universe, he recommends higher-quality stocks, while avoiding the more indebted, lower-quality companies. The median small-cap value stock now has debt that is six times its earnings before interest, taxes, depreciation, and amortization. “That’s a little scary,” he says. “Some of these companies have an awful lot of debt. It’s low-cost now but it doesn’t give them much margin of safety if the economy turns out not to be strong.”
Investors can gain exposure to these themes with exchange-traded funds. Names to consider include the iShares Russell 1000 Value ETF (IWD), Vanguard Small-Cap Value (VBR), and iShares S&P Small-Cap 600 Value (IJS).
These ETFs won’t provide shelter in a torrential downpour, but they could leave investors with some dry powder for another day.
Write to Daren Fonda at [email protected]
