Changing of the Guard: How Market Corrections Lead to New Favorites Going Forward

Posted:
Thursday, November 01, 2018

Regarding the overall market averages, October undid most of the progress for stocks for the calendar year. Regarding the stocks that have led the advance over the past five years, the declines were more significant. For Facebook, Apple, Amazon, Netflix, and Google (collectively referred to as the FAANG stocks for their initials), losses have been as much as 25 percent. Of this group, only Apple has anything that approaches an average market valuation of around 16x earnings. The rest are valued far higher than the market overall.

Growth stock investing tends to focus on rising revenues on the expectation that earnings will eventually manifest themselves. A true growth stock is usually in a nascent industry. Analyzing their potential demand and profit tends to be more art than science since there is no context to correlate their demand relative to the larger economy. For this reason, any earnings forecast, no matter how far-fetched can be acceptable. This is how growth stocks take off.

In this cycle, growth stocks are aided by the reluctance of policymakers to raise interest rates back to a level that cash can earn a legitimate return. Because the return on “safe” investments like savings accounts and certificate of deposits has been minuscule, even risk-averse people have been forced to look for returns in the form of appreciation. Since most growth stocks by definition have revenue growth higher than the overall economy, they become the vehicle of choice when the other component of return (cash flow) falters.

Now the environment is changing. Interest rates are going up, which provides competition from more passive investments. Credit is tighter, as the Federal Reserve sells off its investment portfolio and takes funds out of circulation in the process. Inflation, which in an advanced economy is more in services, is advancing faster than the official rate, which tends to focus on goods. There is some concern about the economy, but more concern for the stability of the future. In an election year, politicians advance the concept of a hostile world that only they can defend us against, and only if re-elected.

If the events of October and prior portend to a correction in market leadership, then at some point new investment concepts should unfold. While it is a bit early to say just what they will be, the implication is that they will not be leaders of the last advance. Research has shown that the leaders of one market cycle have less than a one in twenty chance of leading the next market upswing. This is why often successful growth stock investing consists of jumping off the train before it leaves the tracks, then finding the new concept to jump onto.

One group of investors in growth stocks, who are probably oblivious of their participation, is the investors in index funds. At one point, the FAANG stocks described above counted for over a quarter of the value of the Standard and Poor’s 500 Index. As these stocks fade and others take their place, expect erratic behavior out of the indexes and the corresponding funds.

Into the vacuum left by the stories of growth are value stocks. In contrast to growth securities, value stocks do have earnings and dividends. They may, by their legacy, be unable to paint the picture of Jack and the beanstalk growth that their newer brethren do, but they do not hit a wall and leave no skid marks either. As volatility becomes a more pervasive thing, knowing that a company makes real money, pays real dividends, and has real assets give investors the anchor they need to withstand the crosswinds.

The philosophical difference between growth and value investing is that value tries to know the bottom, with the upside unknown or undefined. Growth tends to look for the upside, with the downside undefined. In a choppy market, the two styles can give the appearance of being similar. When liquidity dries up, neither growth nor value strategies tend to work. Over time, the knowledge that value has a base becomes reassuring, until the next Pied Piper growth story. Then we are off to the races with the growth concept.

Based on what has transpired, it would appear that things will recover towards year end. After that, what happens is a function of fear and hope. This is true of all financial markets.

The Economy

Economic news is good, which is a wonder why Republicans do not mention it. Productivity is up; wages are finally rising, the unemployment rate is at a 49-year low. Only the recent stock market reversal is a skunk at the garden party, especially for a president who campaigned on the idea that the recent record stock market rally was his validation.

While there are many worries, from tariffs to relations with trading partners, it seems the default path is for a somewhat stronger economy going into 2019. However, without the sugar high of the tax cuts enacted in 2018, expect slower growth in profits and the economy going forward.

Interest Rates

Like almost every politician before him, Trump has criticized the Federal Reserve for raising interest rates. Politicians do not like high interest rates, as they can impair an economy in a way the politician gets blamed.

The posturing aside, interest rates will keep going up. By historical standards, interest rates are still low, which enriches the speculator and investor at the expense of the saver. There needs to be a better balance here.

Inflation

Inflation is a matter of whom you ask. Purchasers of services contend inflation is strong, while purchasers of goods marvel at stable prices.

That separation in the inflation rate between goods and services will disappear once the tariffs take hold, which unfortunately for most families will be right before the Christmas shopping season. The tariffs, enacted to bring more manufacturing to the U.S., will at least in the short-run lead to higher prices for imports from China and other targeted importers. A classic case of being careful what you wish for.

The Stock Market

Stocks have slid in October, taking most of the gains for the year with them.

Once the elections are over, we hopefully can reunite the country behind one set of values, which is a different hope from being united behind one political party.

November and December are the months that investors begin looking at 2019 earnings estimates. To the extent that markets thrive on hope, this tends to be the elixir for markets going forward.

Warren M. Barnett, CFA

November 1, 2018

 

 

 

 

 

Warren Barnett, Founder & President, CFA - Barnett & Company

Warren Barnett

Warren Barnett is the founder and President, and Portfolio Manager for Barnett & Company. He was associated with the investment banking firm of Kidder, Peabody & Company and the investment counseling firm of Davidge & Company in Washington before returning to Chattanooga to accept a position in the trust department of a local bank. Perceiving the local need for the type of firms with which he was associated in Washington, he established Barnett & Company in 1983. He obtained the Chartered Financial Analyst professional designation from the Institute of Chartered Financial Analysts, Charlottesville, Virginia in 1986. Mr. Barnett graduated from The McCallie School in Chattanooga. He received his Bachelor of Science degree in Accounting from the University of Tennessee at Knoxville and his Master of Business Administration degree in Finance from the Owen School of Management at Vanderbilt University.

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