Despite sluggish earnings growth, increasingly gloomy forecasts for global economic growth and a noticeable apathy toward equities on the part of many investors, the S&P 500 and the Dow Jones indexes reached all-time highs this past week.
Given new highs, equity valuations look rather full in conventional price-earnings terms, but the risk premium for equities also looks very generous when compared with that of bonds. After all, 65 percent of the stocks in the S&P 500 now yield more than a ten-year Treasury note. We also expect a positive impact on earnings growth into 2017, with the drags from the dollar’s strength and energy weakness fading and the domestic economy expanding.
Equity returns will be modest unless investors have enough confidence to reprice equities to reflect much lower interest rates. So far, they haven’t.
Within the market, the contrast between the haves and have-nots is increasingly stark. For almost two years now, investors have focused on stocks seen as the least risky: dividend payers in relatively stable businesses. Because this focus has intensified again in recent weeks, many of the indicators we use for stock selection have reached the extremes seen in mid-February. Our core team’s measure of fundamental value within the market — dividend discount rate spread — is in the 93rd percentile versus 30-year history, a measure only surpassed during the crisis conditions of 2008–’09. Unmistakable evidence of risk aversion is everywhere. Companies with the strongest balance sheets sell at a 20 percent premium to the market; the weakest, at more than a 20 percent discount. Both metrics are close to 30-year records and were only exceeded during the 2008 crisis.
During the second quarter, the long-trending preference for less volatile stocks with a dividend continued as risk aversion remained a dominant theme. Volatile and heavily traded stocks were the losers. By sector, utilities and telecom continued to lead, both with gains of 7 percent. Many health care stocks performed well, too, but with a huge divergence between the largest — those with low volatility and yield — and the less predictable biotechnology and specialty pharmaceuticals names. Interestingly, some of the best returns — a 12 percent increase, in fact — came from energy, a volatile group with falling dividends but helped by a recovery in oil and gas prices.
Once fundamentals start to look better, stock prices can follow. So how are our investment teams dealing with this? Our core investors are already strongly positioned to take advantage of a less risk-averse mood within the market. Core portfolios feature investments in banks, where the total yield — dividend and buybacks — now looks compelling after favorable stress test results; many low-priced cyclical stocks such as airlines, cars and semiconductors, to name a few; plus stocks with strong growth prospects in media and health care. Utilities, consumer staples and real estate investment trusts are all much less well represented.
At the same time, our growth team is focusing on the winners from disruptive new technologies and secular change across many industries. The team also sees good opportunities in such areas as the U.S. housing market and infrastructure spending. The growth team is not emphasizing the health care sector as much these days, though the group still sees opportunity in biotech stocks that have great pipelines.
Our value investor team also sees financial stocks as a very attractive option. Although the earnings outlook for many financial stocks has weakened, balance sheets look very strong indeed, which to our conservative value team is a very important distinction in support of adding more to these investments at current depressed prices. Conversely, most energy and commodity stocks don’t look appealing.
Whereas investor sentiment and market trends force us to address sector and factor risk in our portfolios, the opportunity on offer by taking a long-term, patient view on stocks we consider undervalued has rarely looked better.
Paul Quinsee is chief investment officer of U.S. equities at J.P. Morgan Asset Management in New York.
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