After weeks of headlines driven by currency moves, geopolitics and commodity prices, it’s time to get back to basics as we enter earnings season. Analysts and companies alike been clamoring over each other to lower expectations on growth, net income, and guidance. In our opinion, the next few weeks will present some excellent bargains due to short-term selling by nervous investors. According to Bank of America’s Savita Subramanian, highlighted by Marketwatch, ‘S&P 500 bottom-up EPS [projection] has come down 8% over the last three months to $27.04—a bigger cut than in any other quarter in recent history’. The actual numbers in the next few weeks, in our opinion, are of limited importance due to the impact of macro factors. Blaming a company that has sales overseas purely because the dollar got stronger isn’t our style. If it has great products and is not a financial firm, we’d much rather focus on how the quality and volumes are looking for their core business rather than how well it’s hedging currencies. Thinking long-term will be the key, and we recommend having some liquidity on hand swoop in on undervalued sectors if the bears start stampeding on Wall Street. With that background, here are some details worth thinking about this week:
Valuations: The 6-year old, seemingly unstoppable bull market continues to keep investors guessing on when it’s going to end. As of last week, according to Yardeni Research, the forward P/E ratio for the S&P 500 stood at 16.6 – higher than the 15.2x P/E at the peak in October 2007, but lower than the 25.6x seen during the dot com bubble in March 2000 (with data from JP Morgan). However, it’s also worth noting that the 10-year treasury yield was at 4.7% and 6.2% during those earlier peaks, compared to below 2% at the moment – meaning investors have had few places to go for yield other than stocks in recent times. Using Blackrock’s data, we see that large cap value stocks have delivered average annual returns of 10.5% over the past 20 years, outperforming small caps and growth stocks. The valuations reflect this, with JP Morgan’s data showing the asset class is now trading above a 16x forward P/E, far higher compared to their 20 year average around 14.3. Meanwhile, when we consider growth stocks, the small, mid, as well as large cap classes are under their 20-year average P/Es. Our opinion remains that with interest rates projected to go up in the coming months, value stocks – averaging a higher dividend than growth stocks, will underperform their peers in the near term. This, now, gets combined with the fact that S&P 500 operating profit margins are looking extremely solid, and cash as a percent of total assets is hovering around 30% – at the highest levels since 2000. Therefore, our belief is that cost cutting is in good shape – the focus will now shift on growing revenues in a slow global growth environment. GE’s sale of its non-core business last week, and the consequently sky-rocketing stock is, we believe, an indicator of the trend ahead. Companies will need to acclimatize to the new era of lean, smaller, fast moving machines, and as a result, spin-offs, M&A activity and segment changes will reward stockholders well. Therefore, even though valuations are looking slightly stretched, we remain cautiously optimistic in the short term, and bullish (as usual) for the long term. With this foundation, our main focus will be on the guidance of companies regarding their individual business units as earnings season unfolds.
Macro: Meanwhile, world markets find themselves at an interesting juncture. Europe continues to trounce the US in returns this year; China, Hong Kong, and Japan’s markets are hotter than ever, and Russia’s currency has shown the best return among its emerging peers year to date – something not too many investors expected. Overall, global markets (via the MSCI ACWI) are at a forward P/E of 16, compared to their 10-year average of 13.1, – showing some possible overheating. While we absolutely do not recommend selling your international holdings, keep your seatbelts on in case of pullbacks. For new positions, selectivity is key. Germany and India’s leaders (two of our favorite regions, for reasons described in our 1/14 and 1/11 columns) are meeting this week, while Mexico’s consumption and investment scene keeps it an attractive investment. Several neglected markets, including Spain, Italy and France, are also on our radar, and for the long term, we recommend exposure to Nigeria. Our reasons are simple – it’s the fastest growing economy on the continent, will have a larger population than the US by 2050 (per UN’s data), and is one of the best entry points for international investors to sub-Saharan Africa. Infrastructure, technology and telecommunication growth will lead the way based on our research, and we believe the growth remains heavily discounted due to near-term politics, regional instability and its dependence on commodities – which will give way to services and consumption-driven growth in the long term.
What it means for you: A diversified portfolio of investments, especially in the span of rising volatility and interest rate, makes sense. Maintain exposure to the US and international markets (via ETFs such as SPY and VXUS), avoid looking at the quarter’s data in isolation of the macro context and freaking out, and enter a solid sector or company if investors start selling on short term news. Importantly, stay invested in your current holdings – and remember the words of one of our favorite columnists, Jason Zweig, from the WSJ – ‘Let the rest of the world grow ever more myopic. In the long run, he who trades the least will end up with the most’. We’re being gifted the best seats in the house to watch the drama; sit back while staying sharp as the bulls and bears figure out which direction to run in on Wall Street.
