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.
The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this weekly review is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results.
Information obtained from third party sources are believed to be reliable but not guaranteed. Envestnet|PMC™ makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.
Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.
Alternative Investments may have complex terms and features that are not easily understood and are not suitable for all investors. You should conduct your own due diligence to ensure you understand the features of the product before investing. Alternative investment strategies may employ a variety of hedging techniques and non-traditional instruments such as inverse and leveraged products. Certain hedging techniques include matched combinations that neutralize or offset individual risks such as merger arbitrage, long/short equity, convertible bond arbitrage and fixed-income arbitrage. Leveraged products are those that employ financial derivatives and debt to try to achieve a multiple (for example two or three times) of the return or inverse return of a stated index or benchmark over the course of a single day. Inverse products utilize short selling, derivatives trading, and other leveraged investment techniques, such as futures trading to achieve their objectives, mainly to track the inverse of their benchmarks. As with all investments, there is no assurance that any investment strategies will achieve their objectives or protect against losses.
Neither Envestnet, Envestnet|PMC™ nor its representatives render tax, accounting or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor.
© 2014 Envestnet. All rights reserved.