PMC Market Commentary: May 16, 2014

A Macro View – Making Sense of the Current Stock Market Rotation

Since the Nasdaq Composite Index hit a 14-year high on March 5, the stock markets have been experiencing a dramatic rotation with high P/E, momentum stocks such as social media and biotech stocks tumbling while low P/E “boring” stocks such as utilities and consumer staples stocks have been jumping. For example, while the S&P 500 Index was essentially flat during 3/5 – 5/9, S&P 500 Consumer Staples Index rose nearly 5% while S&P 500 Consumer Discretionary Index fell about 5%. To some, it feels much like the beginning of the burst of Internet bubble in early 2000 or the risk-on/risk-off environment throughout much of 2010 and 2011.

However, it is our opinion that the fear of the repeat of 2000 is quite unwarranted as the current stock market, though fair-valued to slightly overvalued, bears little resemblance to the stratosphere-like valuation back in 2000. Even the Internet stocks now are much “cheaper” than they were 14 years ago. The worry of the return of the highly volatile risk-on/risk-off environment has some merit, but our belief is that it is different this time around. During the risk-on/risk-off period in 2010 and 2011, stock movement was almost entirely sector-driven and completely in unison. During risk-on, almost all economic-sensitive sectors rose at the expense of economic-defensive sectors. The opposite was true during risk-off. The stock market at this time was driven by emotion and timing was everything.

The current stock market rotation is far more selective, in terms of both sectors and stocks, and driven by valuation. On the sector level, the best-performing benchmark sector is surprisingly not one of those economic-defensive sectors, but energy, a highly cyclical economic-sensitive sector that jumped more than 8%. The strong performance can be almost entirely attributable to its relatively low valuation, as its performance had been lagging other sectors for years. Meanwhile the performance discrepancy among stocks within the same sector is so significant that it has little correlation with its sector performance. For example, although the overall technology sector declined by more than 1%, Apple (AAPL) , by far the largest stock within the sector jumped more than 10% versus a 20% loss of Facebook (FB). Again, it was almost totally due to valuation as the stock price of Apple had been struggling for the past couple of years.

This valuation-driven rotation is not confined to just large-cap stocks, but has taken place in the whole U.S. stock market and international stock markets. For example, while the S&P 500 Index was little changed during the period, the Russell 2000 Index tumbled nearly 8%. Small cap stocks had outperformed large cap stocks by wide margins for the past couple of years and their valuations have become stretched. In the global stock markets, despite turmoil in many places such as Ukraine and Thailand, emerging markets gained nearly 6% during the period, far outpacing developed stock markets. After struggling for years, we think their valuations have become very attractive.

The current valuation-driven rotation is a much-needed, timely reality check on the stock markets. In a raging bull market, investors tend to focus mostly on growth potential and ignore valuations. If this sentiment goes unchecked and develops into extremes, as is the case of most stock market bubbles, a raging bull market will soon become a run-away bull market and the bubble will burst before long. For two years in a row (2012 and 2013), stock market gains were predominantly driven by multiple expansion as a result of investor optimism for the future growth prospects that are yet to materialize. Multiples expansion can’t go on forever and it is time for earnings growth to push the stock markets forward. The current rotation provides a perfect opportunity for investors to cool down their enthusiasm, take a second look at the market and reposition themselves.

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