- We think we are observing a change in markets that could trigger a reversal in the market cycle.
- If history is not violated, as the overwhelming winner of the current cycle, passive S&P 500 returns should be relatively poor over the next market cycle.
- Low correlations of value to growth and momentum have surfaced true value stocks, where prices have fallen below business value.
Market Overview and Outlook
Value investing often boils down to a trade-off. You have historically earned an attractive long-term return, but you must endure painful parts of the journey. This trade-off can therefore be difficult. Just as passing sailors could not resist the siren songs that lured them to their death on rocky shores, many investors cannot resist sacrificing their investment process when performance pain mounts.
Currently, growth and momentum investment styles have converged to beat most value disciplines over this market cycle, and the resulting underperformance for value has intensified since the beginning of 2017. This intensification of the current pleasure of U.S. momentum stocks is like a siren song, and the pain for pretty much everything else is an extreme test for staying tied to the mast and sticking with a value journey.
However, we think this is not the time to abandon the value ship: market conditions are changing. The continued rise in interest rates suggests we are in the early stages of a bond bear market, which could intensify as central banks withdraw liquidity. The receding tide of liquidity will start to reveal more rocks beyond what has been exposed in emerging markets so far, and the value of a value discipline will be in avoiding the biggest capital-destroying rocks. If a rock emerges on the crowded shore of U.S. momentum, it could result in a major liquidity challenge, as momentum is often most intense on the downside as a crowded trade reverses.
Almost all efforts to diversify the major U.S. index, the S&P 500, have diluted realized returns. This unfortunate and unexpected outcome has proven incredibly vexing to asset allocators and has fed a very powerful argument for simply going passive or collapsing active strategies around U.S. momentum. To be clear, we are not making a moral judgment against the current cycle and its leadership dynamics, and we should have done a better job adapting to it within our valuation-driven process. But cycles are cycles. The current one emerged out of the Great Financial Crisis, which had been preceded by a value cycle, which had been preceded by a bubble in U.S. growth stocks. This rinse-wash-repeat pattern is how cycles work, and this cycle will be no different.
Correlations Collapsed in 2017
The frustration with this cycle has really come since the beginning of 2017 when market correlations that are rooted in fundamental logic and history simply collapsed. This collapse has been characterized by a major positive correlation between U.S. growth and momentum on the winning side, and an almost allergic negative correlation between these and pretty much everything else, which has lost. Include value on the losing side, which suffered as valuation multiples for the winners expanded while the losers’ compressed. This multiple-driven gap in relative performance between growth and value occurred even though underlying fundamental metrics, like earnings growth, did not widen (Exhibit 1).
Exhibit 1: Value Underperforming Growth Despite Stronger EPS Growth Expectations
This shift away from fundamental logic hit us very directly in two key sectors, financials and energy, where we had positioned the portfolio to enjoy fundamentals that were improving as key drivers had shifted in our favor. Generally, if you buy a stock below business value and realized expectations in fundamentals improve and start to exceed embedded expectations, you will enjoy price and value convergence. Energy stocks have NOT benefited as oil prices rallied strongly, and financials have NOT enjoyed higher interest rates, as historic correlations and logic would have suggested (Exhibits 2 and 3).
Exhibit 2: Energy’s Divergence from the S&P 500
Exhibit 3: Insurance vs. S&P 500 Has Diverged from the 10-Year Yield
As we are guided by a valuation process that identifies gaps between price and underlying value, the logic of this absolute valuation discipline remains clear to us, but it is being tested by the loud siren chorus shouting the current pleasures of growth and momentum. When the song grew louder as 2017 began, our performance followed value (Exhibit 4).
Exhibit 4: Value Equity Portfolio Has Joined Russell 1000 Value’s Divergence Since 2017
So investors are facing a large potential trade-off right now: continue to bet on the current dominance of momentum and the S&P 500, or bet on change and take an active value bet in names with attractive value and optionality, but with negative momentum.
If you make the first choice, you will enjoy the comfort of being aligned with the prevailing market chorus that is plowing capital into U.S. momentum names and the S&P 500. If you want to minimize current relative performance discomfort, you must fully embrace this crowded choice by going passive, which means taking an active bet on momentum. But again, cycles are cycles. If history is not violated, as the overwhelming winner of the current cycle, passive S&P 500 returns should be relatively poor over the next market cycle. The more immediate risk is that, so far, we have only witnessed historic levels of passive and momentum buying within U.S. stocks. We have never seen this amount of crowded capital try to sell. It seems logical that the scale of the buying helped drive the shift in market dynamics we have witnessed since early 2017, and that a reversal on the sell side will cause an equal but opposite dynamic.
We think we are observing a change in markets that could trigger a reversal in the market cycle. For one, a continued rise in rates that ultimately normalizes the term premium would push the 10-year Treasury to roughly 5%. The current market hegemony would be severely challenged by this shift, and despite very few cracks in U.S. markets, we believe it is underway. Why?
Early Signs of Shift from Momentum and Growth
We are currently witnessing a massive shift in U.S. dollar liquidity as monetary and fiscal policy in the U.S. have shifted. Despite an extremely polarized political system, populism is uniting both extremes in debt-financed fiscal expansion that is daring the term premium to normalize. In effect, populism demands an inflationary response, and when combined with record-tight labor markets, it seems very likely inflation metrics will continue to drift above Fed targets of 2%.
At the same time, trade policy is also inflationary, as it is making global supply chains, which had exported global deflation around the world, much less efficient by taxing them directly. This structural reversal is raising input costs and will require increased capital investment to localize some production capacity.
The inflationary impulse from these massive nonmonetary shifts is forcing U.S. monetary policy to tighten, with the resulting shift in global liquidity squeezing emerging markets (EM) in classic late-cycle fashion. This shift could get ugly if it spreads to other markets, exposing more rocks as the liquidity tide recedes. In EVERY past cycle the locus of every crisis has been where debt has increased the most. This cycle it is in sovereign debt, which has enjoyed unprecedented demand from central banks and market flows. A term premium normalization would put monetary and fiscal policy in a bind, and we are closely observing global risk spreads to see if liquidity concerns are spreading. So far it has been minimal, but the liquidity drain will accelerate in 2019.
For now, liquidity concerns have been contained in EM stress, which has reinforced the dominance of U.S. momentum trends as capital has rushed to U.S. shores. However, the continuation of these trends will put pressure on U.S. profit margins as capital intensity, labor costs and interest costs rise. On the last metric, U.S. corporate net debt has never been higher outside of a recession, and rising rates are a key long-term vulnerability.
Pressure on profit margins is a key risk factor, as earnings growth from the tax cut and faster U.S. economic growth have been offsetting value multiple compression to drive U.S. returns. Earnings growth will naturally slow in 2019, but we would also expect material negative estimate revisions as margins come under greater than expected pressure. The combination of slowing earnings growth, negative estimate revisions and continued multiple compression could create an acute challenge for U.S. momentum. Given the crowding into U.S. momentum and the S&P 500, liquidity is a key risk if current extrapolation is challenged by the pain of missed expectations and any resulting price weakness.
The silver lining is that investors do have a choice. While growth and momentum are currently highly correlated, their correlation to value is historically low (Exhibit 5). In other words, the recent pain from negative momentum has surfaced true value stocks, where prices have fallen below business value. This provides the classic opportunity for active valuation managers to invest in names with much more upside than downside, and where there is cheap optionality from the changes discussed above.
Exhibit 5: Tightly Correlated Relative Performance of Growth and Momentum
Opportunities in a Market Shift: Financials, Energy, Health Care
The clearest example of a current valuation opportunity that could benefit from changing dynamics is in financial stocks, and specifically insurance stocks that will benefit immensely from any normalization in the term premium and higher rates. We did not add any financials this quarter, but we have increasing confidence in supporting our fondness for financials with our holding in AIG. We think the new management team is turning around this global insurance franchise, and that the reduction in expenses and lower insurance losses will start to deliver earnings growth. The internal leverage from a successful turnaround could grow earnings even in a recession, which is a massive and favorable contrast with recession risk for S&P earnings. Despite the potential for scenario-agnostic earnings growth for AIG over the next several years, investors are reluctant to step up, and AIG stock continues to languish at distressed valuation multiples below book value.
Energy is another example of cheap optionality. Since the energy depression in 2016, capital spending has been cut to a level that will not generate enough supply to meet global demand. Yet despite this potential supply cycle and the rebound in oil prices, energy’s weight in the S&P 500 has shrunk to historically low levels as the hangover of the last cycle weighs on the stocks.
An additional benefit and cheap optionality from the financial and energy sectors is that most cycles end on higher interest rates and oil spikes. We are effectively securing cheap insurance from both these cyclical risks, each of which could surface the rock that crashes the current U.S. market party.
Outside of these more traditional value areas, we remain positioned in large-cap drug and biotech stocks. The negative momentum and derating in this sector has been more painful than we expected, but these very high-quality stocks have fallen to prices that are discounting disruption of legacy cash flows and giving us pipeline optionality at an historic discount. Along these lines, we added a small position in Biogen during the quarter. Biogen is the market leader in the multiple sclerosis treatment market and the front runner in the race to conquer Alzheimer’s disease. The company’s current product portfolio has a value around $270 per share. This leaves its Alzheimer’s pipeline priced at about $75 per share, implying that the market only assigns a one-in-three chance that Biogen will succeed in Alzheimer’s. Favorably, Biogen has not one but two drug candidates that have both shown efficacy, albeit in early studies. We think there is a two-in-three chance that the drugs will work, and therefore we view the Alzheimer program as a very cheap option. If Biogen succeeds in Alzheimer’s, the stock could be worth around $550, a 60% upside. If it fails, the stock could fall 20% to the value of its existing business.
"So far, passive and momentum have been buying; we have never seen this amount of crowded capital try to sell."
Finally, we also continue to allocate some capital to non-U.S. names, where the flow of global capital to the U.S. has left cheap optionality in its wake. During the quarter, we added ABB, a Swiss industrial conglomerate company. Trading at 15x earnings, ABB has a slow-growing power grids business concealing the value of the world’s second-largest robotics player within its mix of businesses. Although the secularly advantaged robotics division only accounts for 8% of sales, its growth will likely accelerate given its dominant position in non-automotive industries, which are in the early innings of robotics adoption, and its industry-tailored software offerings. In the long term, a strategic reshuffling, as has been suggested by activist investors, such as a sale of the power grid business and a reorganization of the company to highlight its robotics business and its broader automation products, would unlock significant value. Near term, the cyclical recovery of industrial production in Europe should drive a better earnings outlook.
Value has performed relatively poorly since the 2017 shift, but we believe challenges to the S&P 500’s dominance are mounting and resulting active opportunities away from the index are growing. At some point, this fault line will break, likely on the back of rising rates, and all investors will be reminded that the best time to diversify away from the winners is when it is most painful. The bargain of capturing long-term value may be short-term pain, but enough is eventually enough and it comes time to harvest the benefits.
The ClearBridge Value Equity Strategy had a positive return during the third quarter, underperforming the Strategy’s benchmark.
On an absolute basis, the Strategy had gains in seven of the 11 sectors in which it was invested during the third quarter (out of 11 sectors total). The primary contributors to the Strategy‘s performance were the information technology (IT) and health care sectors.
In relative terms, the Strategy underperformed its benchmark primarily due to stock selection decisions during the quarter. Stock selection in the consumer discretionary, financials and health care sectors detracted the most from relative returns during the period. An overweight to the energy sector and an underweight to IT also weighed on returns. Conversely, stock selection in IT and the newly created communication services sector, which expands the telecommunication services sector to include select companies from the consumer discretionary and IT sectors, contributed positively to relative results. An underweight to communication services likewise boosted relative returns.
On an individual stock basis, the greatest contributors to absolute returns during the quarter were positions in Microsoft, Oracle, Allergan, QUALCOMM and Alphabet. Royal Gold, Adient, Melco Resorts and Entertainment, Devon Energy and Realogy were the largest detractors from absolute performance.
During the quarter we initiated positions in Biogen and ABB. We closed our position in Hanesbrands.