By Gary Stringer, Kim Escue and Chad Keller, Stringer Asset Management
We think the recent stock market volatility is likely to persist and that equity prices will ultimately move higher. Volatility is a sign of uncertainty and the market is telling us that it is less confident in the prices of assets. Importantly, this uncertainty does not clear itself up quickly and volatility tends to linger. Essentially, one day’s wider price swing tends to endure into the following days and weeks. As the following exhibit illustrates, periods of high volatility persist until periods of lower volatility take over, and this cycle repeats over time.
In addition to headlines about trade wars and interest rate moves, our signals suggest that the recent volatility in the market has a lot to do with the decline in the pace of global economic growth (exhibit 2). Though we think that engaging in a trade war would be a significant U.S. policy blunder, the risk and impact to the U.S. should be relatively muted. While trade is clearly beneficial, it is not as impactful to the U.S. economy as it is for many other countries. For example, trade as a percentage of GDP for the U.S. is roughly half the global average (exhibit 3).
At the end of the day, economic growth, even sluggish growth, leads to higher revenues and earnings, which can support higher equity prices. Furthermore, we do not think interest rates will move significantly higher in the near-term.
INVESTMENT IMPLICATIONS
In high volatility regimes like the one we are currently in, investors should look towards lower volatility strategies and investments. We think nominal GDP (NGDP) growth, which had been moving at an impressive rate in late 2017, will likely decelerate nearer to its long-term trend of roughly 4% (2% real GDP plus 2% inflation) over the next six to 18 months. Given the long-term relationship between NGDP and the 10-year Treasury yield, we expect that softer NGDP growth will move the 10-year Treasury yield lower to approximately 2.5% (exhibit 4).
This environment should bode well for the defensive interest rate sensitive sectors that tend to perform well with falling long-term rates, such as low volatility global equities, REITs, merger-arbitrage strategies, and longer-duration high quality bonds.
Notwithstanding the market volatility, we think the recent equity market declines, combined with increased earnings expectations, make both domestic and foreign equities more attractive than they were at the start of 2018. For example, analysts have increased their forward 12-month earnings expectations for the S&P 500 Index’s companies by more than 16% since the beginning of the year. Additionally, in light of the recent equity market declines, the forward price-to-earnings (PE) ratio of the S&P 500 Index has decreased more than 15%.
Finally, we expanded our bias in favor of value equities compared to growth equities during the past quarter. We noted last fall that the relative outperformance of U.S. growth stocks over value had become extreme by historical standards and that outperformance has now expanded globally to foreign developed and emerging markets. We have long been believers in reversion to the mean, which leads us to think that the gap between the investment performance of value stocks will eventually catch up to growth stocks.
As a result, we widened our value bias to developed and emerging market equities, in addition to the domestic overweight that we emphasized last fall. Exhibit 5 shows the rolling 12-month return differential between the growth style and the value style in the U.S. as well as the developed and emerging markets. The growth style of investing rarely outperforms the value style by the magnitude we have seen recently. We think there is a strong probability that the value style will outperform over the next twelve months.
Despite the volatility, we think that investors can be rewarded with attractive returns in the mid-to-high single digits from the equity markets compared to low single digit returns from high quality fixed income in the current market environment.
This article was written by Gary Stringer, CIO, Kim Escue, Senior Portfolio Manager, and Chad Keller, COO and CCO at Stringer Asset Management, a participant in the ETF Strategist Channel.
DISCLOSURES
Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management, LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not be taken as an advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested.
Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.
The securities identified and described may not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.
Data is provided by various sources and prepared by Stringer Asset Management, LLC and has not been verified or audited by an independent accountant.
Index Definitions:
S&P 500 Index – This Index is a capitalization-weighted index of 500 stocks. The Index is designed to measure performance of a broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
Russell 3000 Growth – This Index is a market capitalization weighted index based on the Russell 3000 Index and is used to provide a gauge of the performance of U.S. growth stocks. The Russell 3000 Growth Index includes companies that display signs of above average growth.
Russell 3000 Value – This Index is a market capitalization weighted index based on the Russell 3000 Index and is used to provide a gauge of the performance of U.S. value stocks. The Russell 3000 Value Index includes companies that display lower price-to-book ratios and lower expected growth rates.
MSCI EAFE Growth Index – This Index captures large and mid-cap securities exhibiting overall growth style characteristics across Developed Markets countries around the world, excluding the US and Canada. The growth investment style characteristics for Index construction are defined using five variables: long-term forward EPS growth rate, short-term forward EPS growth rate, current internal growth rate and long-term historical EPS growth trend and long-term historical sales per share growth trend.
MSCI EAFE Value Index – This Index captures large and mid-cap securities exhibiting overall value style characteristics across Developed Markets countries around the world, excluding the US and Canada. The value investment style characteristics for Index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield.
MSCI EM Growth Index – This Index captures large and mid-cap securities exhibiting overall growth style characteristics across 24 Emerging Markets (EM) countries. The growth investment style characteristics for Index construction are defined using five variables: long-term forward EPS growth rate, short-term forward EPS growth rate, current internal growth rate and long-term historical EPS growth trend and long-term historical sales per share growth trend.
MSCI EM Value Index – This Index captures large and mid-cap securities exhibiting overall value style characteristics across 24 Emerging Markets (EM) countries. The value investment style characteristics for Index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield.