A Balanced Approach

Ah, The Big 10 has decided to play football this season, reversing its decision to cancel all fall sports.  What a relief to football fans all over the country who were having a difficult time imagining an autumn without college football, which represents the heart and soul of campus communities all over the nation.  Like almost everything else, this season won’t be a normal one, with no fans in the stands, no non-conference games, and athletes and coaches living in a protective bubble, whatever that means.

The “Great Virus Crisis,” as noted economist Dr. Ed Yardeni has called it, is still impacting virtually every aspect of our lives.  Nevertheless, every day we get closer to a solution, as research labs around the world are working diligently to discover an effective vaccine.  It’s only a matter of time until science solves this problem. 

In the meantime, the GVC’s impact on the stock market has pretty much run its course.  Unless every potential vaccine currently in clinical trials fails, I don’t envision another significant downturn driven by Covid-19 developments.  In a nutshell, the market has discounted the economic impact.  The speed and magnitude of the recovery is now going to be more of a driving factor for the market.  On that note, the recovery will be far from a smooth one.  Even within industries, the rate at which earnings recover will vary depending on how well companies have adapted to the challenges caused by the pandemic. 

Will the stock market continue to be led by the same familiar names – Facebook, Amazon, Netflix, Google, Tesla, Microsoft, and Apple?  Or will out of favor sectors – Financial, Energy, and Cyclicals drive a reversion to the mean?  The recent performance gap between the aforementioned leading “growth stocks” and the underperforming “value stocks” has never been greater.  Large Cap Growth stocks have appreciated 33% over the past year, while Large Cap Value stocks have actually depreciated over 3%.  Like the eventuality of an effective vaccine, reversion to the mean will happen eventually.  What does this all mean for investors?

It seems reasonable for investors who own substantial positions in these highly successful, leading growth names (FANGTMA) to continue to do so, but it would be a valuable exercise to limit the percentage held in these names in relation to the size of one’s overall portfolio, particularly if they continue to appreciate at the same pace.  One of the most challenging investment decisions to make is when to sell a stock that keeps going up.  Invariably, few investors do this well, primarily because they become too emotionally attached.  A better approach is to set a target price and then manage the position incrementally within predetermined active-bet limits.  In other words, compare the percentage weight of the holding relative to your overall portfolio v the percentage weight of that stock in the benchmark.  In essence, easing into a stock, then easing out of a stock in phases, can be an effective way to remove the emotional attachment which so often prevents prudent investment decision making.

What might cause this “growth” v “value” reversion to the mean?…  As we saw briefly earlier this month, a sharp market correction is often led by the same stocks that led the prior advance.  Most of the FANGTMA names fell more than the market during the pull-back in early September.  An extended market correction, if one occurred, would most likely spur further profit taking in this group, causing these stocks to lead on the downside.

Additionally, should any other geopolitical event cause an economic downturn, value stocks would likely hold up better.  While the Fed is doing all they can to extend the economic recovery, the potential for higher taxes and onerous regulation is always a threat to global economic growth. 

Balance seems warranted… From an equity portfolio perspective, it makes sense to have a balanced approach.  Maintain reasonable exposure to the leading growth names, while steadily and deliberately adding exposure to high quality, out-of-favor value names.  Your investment team is focused on doing exactly that. 

Michael Kayes, CFA

The Whole Truth and the Path to Fairness

I am getting asked a lot lately if I watched any of the speeches at either political convention. A corollary question often follows – How is the election outcome likely to impact the economy and markets? I didn’t watch a single minute of either convention, on purpose. None of it, on neither side. Reminds me of this story…

A teenager borrows his dad’s car to attend his senior prom in high school. The evening goes particularly well. In fact, he falls in love, has the romantic evening of his life, but on the way home he sideswipes another car putting a big dent along the passenger side of his dad’s car. When he gets home, his dad asks, “How was your evening?” His son replies, “The prom was amazing, I had a great time.” Then he goes upstairs to bed.

Was he being honest? Technically, yes. Comprehensively and morally? Of course not.

That, in a nutshell, is why I don’t listen to political speeches or sound bites, especially during an election campaign.

How important is the election outcome to the economy and markets? While there are only four basic election outcomes, there are several more potential scenarios involving substantive change to legislative and regulatory policy. Let me try to explain. Assuming the House is not in play, the first two potential outcomes are: The Republicans win the presidency and hold the Senate, or they win the presidency but lose the Senate. Conversely, the Democrats could win the presidency and the Senate, or just the former, but not the latter. Four potential outcomes. However, it is unclear what any new administration or Congress will then attempt to accomplish, particularly if we have split government. Beyond that, even if the Democrats sweep, it is unclear in what direction they will turn. Will they begin with more “moderate” initiatives or try to push a more “radical, progressive” agenda? The net of all this is that there is too much uncertainty to make significant investment bets which are dependent on a certain election outcome. It will be important to be ready to adapt and adjust portfolio strategies. Depending on which party garners the most political power, there may be significant winners and losers across multiple industries and sectors. Virtually every aspect of our economy is subject to political developments, but they are difficult to predict and subject to continual revision.

Enough about politics. What else matters?… The Fed has signaled that interest rates are likely to remain near zero for an extended period. With the federal debt and deficit seemingly out of control they have little choice. Zero interest rates create a powerful tailwind for stock price valuations. But this valuation tailwind does not blow uniformly. With the post-Covid shutdown-economy still struggling to recover, earnings growth has been lackluster across most of the corporate sector. At the same time, driven by innovation and changing demand trends, several companies have managed to exceed earnings expectations and achieve accelerating profit growth. For these select companies, the valuation tailwind is like a powerful hurricane. In essence, it’s a “growth-scarcity premium” and it is extremely powerful. Going forward, it is likely to propel valuation on successful growth stocks much higher than historical levels.

Nothing grows to the sky… It is important to be ever vigilant to valuation levels achieved by these growth-scarcity winners. Moreover, if there is any crack in the fundamentals these stocks can plummet very quickly. Part of our ongoing research and portfolio management process is to continually retest and challenge the fundamentals of each of these leading companies. The art in this process is determining how long to let these winners ride as valuation levels expand beyond historical norms. There is a risk-management aspect to this as well. For each portfolio strategy, we set limits as to how big individual stocks can get in terms of the percentage of the total portfolio. This is one way to manage the risk in this environment of zero interest rates, slow economic growth, political uncertainty, and a stock market that keeps making new highs.

I am also frequently getting asked questions related to fairness. The question seems complicated to many, but maybe it shouldn’t be. Reminds me of another story…

When I was a young boy, my sister and I routinely fought over who would get to eat the last piece of pie. My mom solved this dilemma by giving each of us the choice of being either the one to cut the piece in half or the first to choose which slice they wanted to eat. Both of us learned that the only logical decision was to cut the piece exactly in half, which we did with incredible precision.

How broadly could we apply that approach today? I’ll give that some thought for next month’s edition of Exencial Views. In the meantime, send me your thoughts. Together maybe we’ll discover the whole truth, and nothing but the truth…

Michael Kayes, CFA