Despite some recent choppiness, stock market averages continue to hover near their all-time highs – but that masks a subtle shift occurring beneath the surface. Lately, cyclical stocks, or those most dependent on economic strength for profits, have been consistently outperforming growth stocks.
In 2020, investors were rewarded by playing defence as dependable growth stocks massively outperformed economically sensitive issues during the worst months of the pandemic. Over a large part of 2020, consumers stayed at home either by choice or in compliance with government-mandated mobility restrictions. The ‘stay at home’ theme favoured more innovative growth sectors such as internet-based eCommerce, telehealth and digital streaming. But that trend has suddenly reversed in a shift which could continue for a while longer.
Market practitioners know that stock prices tend to lead economic results by up to six months. In this case, even though the global economy has not fully recovered from last year’s recession, many of the hardest hit sectors of the market have already rebounded sharply. As vaccines continue to be rolled out and the news flow on COVID-19 cases and deaths becomes increasingly positive, further progress is likely.
Value stocks are typically more closely tied to economic activity than growth stocks. Mature companies in slower growing industries tend to trade at lower price multiples of earnings and cash flow, placing them in the value category. In contrast, higher growth companies typically command premium prices as investors expect these companies to grow earnings and cash
Since the beginning of the year, the Russell 1000 value index is up 14.1% versus just 1.3% for the Russell 1000 growth index, representing outperformance of 12.8%, as of this writing.
The most economically sensitive sectors, including energy, financials and small cap stocks,
have performed substantially better than the market on the back of improving global
Given the high efficacy of our vaccines, distribution rates and inoculation percentage levels are key statistics to watch. According to Bloomberg data, more than 1.19 billion doses of
the vaccines have been administered across 175 countries, representing the largest vaccination campaign in history. In the US, 248 million doses have been given so far with a recent run rate of about 2.19 million doses per day.
Wall Street analysts are seeing light at the end of the tunnel. J.P. Morgan recently reiterated their call for a value play: “We believe this move is likely to accelerate as we move into late
spring and the summer amid the reopening of the economy, with the primary beneficiary being value and cyclical stocks. Importantly, we do not believe these developments are priced in, and believe the reopening and reflation trade will resume with a move that will be bigger than we saw early this year.”
In the equity market, cyclical stocks have been reacting much better to earnings news than
their growth counterparts. Last month Netflix, often seen as the poster child for the ‘stay at
home’ growth theme, reported a challenging quarter which sent the stock tumbling 10% on
the day. Last year’s pandemic-induced subscriber growth slowed faster than expected as people previously stuck at home began venturing out.
On their conference call, Netflix announced their video-streaming service added 4 million
more worldwide subscribers from January through March, its smallest Q1 gain in four years.
By comparison, banking and financial services bellwether J.P. Morgan has outperformed
the market by over 500 basis points since reporting a 49.3% upside earnings surprise
on 14 April. Bank stocks benefit from both economic growth and higher interest rates
which have been climbing due to the improved economic outlook.
Although our base case is for a gradual reopening, there will likely be a few bumps in
the road. For example, last week’s payroll report highlighted some of the challenges in getting the world back to work. For the month of April, US non-farm payrolls increased by a mere 266K, just a fraction of the consensus estimates for up to 1 million new jobs. On top of the weak headline number, revisions to earlier months lowered employment in February and March by a combined 78K more than previously reported.
While more vaccinations and a broader economic opening is bringing workers back into the labour market, enhanced unemployment benefits are also discouraging some of them from returning. Furthermore, a record low drop in wages last month was driven by additional workers being added in low-paying industries.
April’s jobs report, however, could fall into the ‘bad news is good news category’ by dismissing some of the recent tapering talk. Investors generally fear a reduction of central
bank bond purchases or an increase in interest rates which could derail progress in both the
value and cyclical spheres of the market.
Going forward, investors should strive to stay well diversified. After the decadelong run-up in growth stocks led by the so called FAANGs – an acronym for mega cap growth stocks such as Netflix and Amazon – these positions have likely become a significant portion of many portfolios. But it may not be too late for some adjustments.
That said, we are continuing to see important growth themes which are likely to play out over the coming years. Expect innovative technologies applied in financial services, retail, manufacturing and healthcare to continue disrupting existing business models. Indeed, many value stocks are cheap for a reason and may become even cheaper if they are unable to adapt in a rapidly changing world.
By some estimates, the pandemic has pulled forward three or more years of innovation as
technology has become our fallback position. Therefore, a well-designed growth stock strategy should continue to have an important place in most accounts. Just be prepared for
greater volatility in technology-heavy indices such as the NASDAQ.
On the value/reopening side of the equation, investors should be aware that some of the reopening theme has been already been factored into current prices. For example, we
see many restaurant, physical retail and hotel stocks currently trading at or above their prepandemic levels of early last year. For these stocks to work, everything must go perfectly on the reopening front and investors must assume a travel-and-mobility scenario even better than we experienced prior to COVID-19.
Bryan Dooley, CFA is Head of Portfolio Management at LOM Asset Management Ltd in Bermuda.
Please contact LOM at +1 345 233-0100 for further information.
This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.