Market Excesses and Irrational Behavior
September 21, 2018
After a volatile start in 2018, including a 10 percent correction, markets have fully recovered and are reaching new highs (Exhibit 1). Supporting these gains has been strong earnings growth, partly due to the impact of tax reform and strong top-line corporate revenue gains, and partly due to a generally positive backdrop of economic growth.
Despite its late stage, the expansion has yet to exhibit the classic signs of an impending end. Typically, we see a buildup of excesses from consumer and/or business overspending, sustained higher inflation, and/or a Federal Reserve that feels the need to press harder on the monetary policy breaks. Excessive spending is not readily apparent in the data we review, and both inflation and the Fed’s tightening path appear relatively moderate within the context of a late-stage expansion. As a result, we anticipate market gains will continue alongside the ongoing growth of the economy and corporate profits.
- Markets are hitting new highs justified by strong earnings growth and reasonably solid economic performance in this tenth year of the expansion.
- Absent the traditional economic warning signs, equity markets are exhibiting some unnatural distortions.
- The stock market is becoming quite concentrated in a select group of growth names, and investors appear overly willing to invest in growth stories across the capitalization spectrum.
- However, such distortions, while identifiable, have yet to reach more extreme levels that we have seen in the past.
- Investors should continue to position portfolios to participate in ongoing growth, but should be building in an appropriate degree of protection and a tilt toward value over growth.
Exhibit 1: Stock Market Hitting New Highs Following Rough Start to 2018
Source: Glenmede, FactSet Data through 9/7/10
Data shown is the historical price of the S&P 500 index. This represents past performance, which is not indicative of future results.
Signs of Market Distortions
While we are not seeing the typical economic excesses that tend to precede the end of an expansion, investor behavior is becoming distorted. A few companies, the FAANMGs—Facebook, Apple, Amazon, Netflix, Microsoft and Alphabet (Google)—have disproportionately driven year-to-date market returns. These stocks have delivered approximately half of the year-to-date S&P 500 index returns.
Exhibit 2: Market Leadership Is Concentrated
Source: Glenmede, FactSet, Morningstar Data through 8/31/2018
In fact, the largest five stocks in the S&P 500, the FAANMGs minus Netflix, now account for over 16 percent of the total index (Exhibit 3). Let that sink in: five stocks account for 16 percent of a 500-stock index. This may feel uncomfortably familiar—we experienced a similar phenomenon during the late 90s technology boom and stock market bubble.
Exhibit 3: Market Concentration in Top Names Mirrors a Past Distortion
Source: Glenmede Investment Research, FactSet Data through 8/30/2018
* Return for the top 5 constituents of the S&P 500 index relative to the return on the S&P 500 index as a whole, annualized. Currently, the largest 5 stocks are Apple, Amazon, Alphabet, Microsoft and Facebook. Performance shown is relative to the S&P 500. Past performance is not indicative of future results.
While comparisons to the dot-com bubble are unsettling, investors should not jump to rash conclusions. While U.S. equities exhibit above-average valuations on the whole, these valuations are nowhere near as stretched as they were during the 1999-2000 stock market bubble. Overall, equity market P/E ratios are near 18x forward earnings, well short of the over-20x multiples during that bubble. Instead, investors should take the illustration above for what it actually suggests: there are unusual distortions in how investors are valuing certain companies relative to others. In the past, such market concentration distortions have been followed by a period of material underperformance by the top 5 stocks—on average 5.5 percent over the next three years—to correct for their disproportionate run.
The Growth-Value Divide
Another way to view these distortions is to divide the universe into growth and value stocks, and observe the differences in performance. Growth companies exhibit above-average growth in recent earnings reports, are expected by analysts to provide above-average growth going forward, and are awarded premium valuations. Current examples would include Facebook and Amazon. Value companies are defined by the opposite characteristics: slower growth in past reports, more modest growth expectations and discounted valuations. Examples include more established companies like JP Morgan and Walmart.
While investing in the growth companies versus value companies is different, their respective longterm performance is actually quite similar, with only a slight advantage—<1 percent per year— accruing to the value group. Current valuation of growth companies is often inflated to factor in their excess expected growth. As this growth occurs, valuations simply return to normal levels, acting as an offset. In contrast, value companies tend to see their valuations rise to average levels as their earnings improve, but along the way, they still experience less cumulative fundamental growth.
Exhibit 4: Investors Appear Overly Enamored With Growth Stories
Source: Glenmede, FaceSet Data through 8/31/2018
Value - Growth Trailing 5yr Total Returns is the 5-year return difference between the Russell 1000 Value and the Russell 1000 Growth total return indices. Past performance is not indicative of future results.
Despite these differences between growth and value, there are periods when investors flock to growth companies and others when they sell growth stocks in favor of value. Recently, growth has outperformed value disproportionately, averaging approximately 6 percent per year for the last five years (Exhibit 4). Again, there are parallels to the late 1990s growth-driven surge, although, as with valuations in general, the 90s market was more extreme. Historically, when performance gaps of this magnitude have occurred, value stocks have regained ground from growth stocks over the next three years 78 percent of the time, on average outperforming by nearly 9 percent over the period.
More Evidence of the Reach for Growth
The current investor appetite for future profits is not confined to established growth stocks. The quest extends across a broad spectrum of markets. Initial public offerings of companies with negative earnings have risen significantly, accounting for more than 70 percent of all IPOs in 2017 (Exhibit 5). Investors seem more than willing to give new companies a relatively long leash to turn their first profit. Again, we must acknowledge the similarity to the 1999-2000-tech boom, although we suspect the current trend has yet to run its course.
Exhibit 5: The Love for Growth Is Also Affecting the New Issue Market
Source: Glenmede, Topdown Charts, Prof Jay R. Ritter Data through 12/31/2017
One last piece of evidence that investors are overly willing to fund growth is seen in the persistence of zombie companies. Zombie companies are firms that have not generated positive cash profits over the previous three years. They must fund their operations by spending excess cash reserves raised through debt or equity offerings. Today, these firms account for a historically significant 9.5 percent of companies (Exhibit 6). In contrast to past cycles, these companies have managed to accrue relatively large cash reserves—four years’ worth. While they may be unprofitable, these zombie companies, on average, have a long runway for their business models and investors appear quite willing to keep injecting funds until they take off.
Exhibit 6: Investors Appear Willing to Wait for Future Profits
Source: Glenmede, FactSet, Bank of International Settlements Data as of 8/31/2018
*“Zombie” companies are defined by the Bank of International Settlements as companies whose operating profits (earnings before interest, taxes, depreciation and amortization) do not cover their interest costs for three years in a row.
**Zombies (<2yrs of Cash): Zombie companies that have less than 2 years of cash on hand to cover all cash expenses.
Strategy: Invest to Participate and Protect
So, what should investors do? Given the economic expansion appears likely to continue, investors may want to maintain a full/neutral weight to equities to benefit from the ongoing growth. As suggested by the Keynesian quote at the top of this article, markets can remain extended for prolonged periods— and rise to even higher levels (Exhibit 7). Eventually, however, valuations will moderate, either as a result of a gradual reversal from excess, a change in economic circumstances, or a combination of both.
Exhibit 7: Markets Can Remain Extended for Prolonged Periods
Source: Glenmede, MSCI Data as of 8/28/2018
Long-term fair value is based on normalized earnings, cash flows and book value using MSCI’s USA Index. Past performance is not indicative of future returns. This is an unmanaged, total return index with dividends reinvested. One cannot invest directly in an index.
Importantly, the reward for taking on risk now is lower than it has been in the past. Unable to perfectly predict the timing or cause of a downturn, investors should deploy defensive strategies within their equity allocations to build in protection on the margin. Defensive equity strategies invest in portfolios of stocks or companies that are inherently more stable than the broad equity market and experience smaller declines during difficult economic and market periods.
The current distortions in the equity markets are meaningful enough to merit incremental action. This means that while we have maintained relatively balanced allocations between growth and value, we are beginning to shift that allocation toward the value side of the spectrum. Our transition is intentionally slow, mindful that such distortions have the potential to be surprisingly persistent.
Further, there remain pockets of relative value, particularly in international markets like Japan. Lastly, alternatives such as absolute return or hedge funds, as well as fixed income, can help balance out portfolio risk.
What Should Investors Do?
In short, we think investors should tilt portfolios on the margin to value opportunities, position themselves to participate in further upside from the ongoing expansion and build in appropriate protection against any unexpected downside risk.
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