Both investors who favor momentum stocks and those who focus their portfolios around high-quality stocks have probably had a very difficult 2016 so far, but for very different reasons. As a result, it may be a good idea to include both in investment portfolios particularly in light of the macroeconomic changes that are going on right now. Fundstrat advises investors to choose value stocks to take advantage of the weakening U.S. dollar and momentum stocks to benefit from the easing credit environment.
2016 brought two different problems
Fundstrat Global Advisors analyst Thomas J. Lee and his team said general investor sentiment suggests that two problems prevail right now. Some investors reported being defensive at the beginning of the year, did well in January but then lost quite a bit of ground over the last six weeks. Others were apparently “caught in a downdraft” in January, but the February rally wasn’t enough to bring them back up to flat for the year.
Lee said this year has brought both “divergent sector performance” like what we saw in the second half of the year and also “sector reversals that were not ‘fundamental’ based.” He noted that large-cap Healthcare and Financials stocks have underperformed but that this hasn’t been as much of a problem as the Utilities sector’s massive outperformance.
Mid-cap Basic Materials stocks have outperformed by about 900 basis points or 1,220 basis points in mid-cap value stocks. Small-cap Healthcare stocks caused the same problems as large-cap Healthcare stocks.
Momentum and high-quality stocks taking a toll
Lee said that currently, investors are positioned for a strong U.S. dollar and are overweight on momentum and high-quality stocks, although these stocks have been underperforming since early last month.
He thinks that most investors expect the U.S. dollar will remain where it is, although he believes it will weaken even more. The reasons given for not believing the U.S. dollar will weaken more are: “divergence of monetary policy and divergence of GDP growth rates.” However, he believes the recent currency moves can be explained by relative inflation.
He also said growth investors usually favor momentum and high-quality stocks, which means that they’ve been hurting because they’ve been underperforming with an 810 basis point differential in momentum stocks and 820 basis point differential in high-quality stocks.
An investor’s dilemma
As a result of all the market turmoil, he said investors are facing a dilemma: “‘hope’ for a catch-up in momentum and quality or put on the ‘correlation trade’ and buy Value and Low-quality.” He notes that improvements in economic data throughout the month of February has coincided with improvements in the stock markets. He also noted three other improvement correlations: high-yield, oil prices and U.S. dollar.
Lee adds that there’s no general consensus that anything at all has improved and that some clients even think that the global economy is falling into a recession. However, he advises that investors focus on “correlation trades” if “the three biggies” are improving because he believes “fundamentals will soon reflect these improvements but with a significant lag.”
Value stocks to leverage USD’s weakening
One of the correlation trades he recommends is choosing value stocks to benefit from the weakening U.S. dollar.
He said value stocks have the greatest inverse correlation to the U.S. dollar, which makes them a good bet at a time when the dollar is weakening. He notes that this inverse correlation can’t be entirely explained by sector weights, but he thinks it may partly be due to the Fed’s economic stimulus and earnings upside from a weaker dollar. Hence, he suggests that companies with better growth prospects may offer opportunity in their value stocks.
Low-quality for easing credit climate
He likes low-quality stocks for their inverse correlation with high-yield, which he said makes sense because “lower ROE and lower margin companies disproportionately benefit from easing credit.”
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