Fundamentals Suggest Impressive Risk-On Recovery Will Continue

Thus, most of the underperformance of portfolios occurred during the timeframe 6/11–9/20 as the market starkly bifurcated, with the S&P 500 large-cap index continuing to rise on the backs of defensive sectors and mega-caps while risk-on cyclical sectors and small-mid caps fell. But this was not healthy behavior (and unwarranted, according to our model), and ultimately, the broad market sold off in Q4, led to the downside by mega-caps AMZN and AAPL. As the S&P 500 hit the depths of its selloff on the Christmas Eve “capitulation day,” investors in my view were essentially pricing stocks for a global recession and 5% Treasury yields.

But the reality is that the economic outlook and corporate forward guidance remained stable, or in many cases improved, while interest rates remained low. So, as a result of the selloff, forward stock valuations were much more attractive going into 2019, setting up a terrific buying opportunity – particularly among the small-mid caps and cyclical sectors that typically thrive in a growing economy. For example, a cyclical industry like Steel (using an ETF proxy like SLX) started 2018 at a 14.2 forward P/E, but by the end of the year it had fallen to a meager 6.4 despite little change in outlook. Not surprisingly, the market has been quite strong ever since that panic-stricken Christmas Eve, led by cyclicals and small-mid caps. In fact, all 12 of our 2018 Baker’s Dozen monthly portfolios have handily outperformed the benchmark on a gross performance basis ever since – averaging +27.0% vs +18.8% for the S&P 500 from through 2/20/19 when the Jan portfolio terminated, and the 11 Feb-Dec portfolios have averaged +27.1% through 3/1/19, vs +19.7% for the S&P 500. This even outperforms the +25.7% performance put up by a pure small-cap index like the Russell 2000. This impressive performance has served as an encouraging reminder that timeless growth-at-a-reasonable-price (GARP) investing is not dead.

Post-drawdown recoveries

Of course, holding small-mid caps and cyclicals displaying strong growth forecasts, solid earnings quality, and attractive forward valuations is normally the profitable thing to do when the economy is growing and interest rates are low, but it sure didn’t work very well in 2H2018. Overall, the actual aggregate earnings growth of our February 2018 portfolio came in 18% better than expectations at launch, but the forward P/E fell 20%, as shown in the table below.

Feb Baker's Dozen constituents and valuations

That’s not the way it’s supposed to work when your stocks produce even better earnings than expected. As a result, the forward valuations of these names are much more attractive today, with some displaying single-digit forward P/Es, even after the bullish recovery of the past two months. Our model-driven approach simply seeks strong growth at a reasonable price, but we can’t predict irrational investor behavior. Fortunately, investors being nonaligned with fundamentals is normally a transitory phenomenon, and history has shown that stock prices eventually reflect fundamentals. And unless guidance is suddenly slashed due to a major unforeseen macro event, we expect quality stocks like these from risk-on market segments to continue their impressive recovery, as valuations seem more reflective of a recessionary economy and much higher interest rates.

SPY Chart Review:

The SPDR S&P 500 ETF (SPY) closed Monday (March 4) just below 279.38. After that scary “capitulation” day on Christmas Eve, investors have been loath to do much selling, likely in fear of missing out on further upside. I continue to expect price to pullback for some much-needed consolidation and profit-taking – if for no other reason than working off overbought technicals. Price has hit strong overhead resistance around 280, and the last two daily candlesticks (a doji and a “hanging man”) indicate a likely pullback. Oscillators RSI, Slow Stochastic, and MACD are all seeking to pull back from extremely overbought territory. This should finally bring price down a bit and allow the bulls to gather new troops and renew conviction before another challenge of the 280 level. All of the key daily moving average curves were successfully recaptured, including the 20, 50, 100, and 200-day. You can see in the chart that the 200-day simple moving average offered temporary resistance in early February, but the second attempt several days later was successful.

SPY chart

Latest Sector Rankings:

Relative sector rankings are based on our proprietary SectorCast model, which builds a composite profile of each of over 600 equity ETFs based on bottom-up aggregate scoring of the constituent stocks. The Outlook Score employs a forward-looking, fundamentals-based multifactor algorithm considering forward valuation, historical and projected earnings growth, the dynamics of Wall Street analysts’ consensus earnings estimates and recent revisions (up or down), quality and sustainability of reported earnings, and various return ratios. It helps us predict relative performance over the next 2-6 months.

In addition, SectorCast computes a Bull Score and Bear Score for each ETF based on recent price behavior of the constituent stocks on particularly strong and weak market days. A high Bull score indicates that stocks within the ETF recently have tended toward relative outperformance when the market is strong, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well (i.e., safe havens) when the market is weak.

Outlook score is forward-looking while Bull and Bear are backward-looking. As a group, these three scores can be helpful for positioning a portfolio for a given set of anticipated market conditions. Of course, each ETF holds a unique portfolio of stocks and position weights, so the sectors represented will score differently depending upon which set of ETFs is used. We use the iShares that represent the ten major U.S. business sectors: Financial (IYF), Technology (IYW), Industrial (IYJ), Healthcare (IYH), Consumer Goods (IYK), Consumer Services (IYC), Energy (IYE), Basic Materials (IYM), Telecommunications (IYZ), and Utilities (IDU). Whereas the Select Sector SPDRs only contain stocks from the S&P 500 large cap index, I prefer the iShares for their larger universe and broader diversity.

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Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account ...

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