Recovery In Stocks Continues As The Fed And China Become More Cooperative

There is a stock market adage that says, “as goes January, so goes the year”. Well, if that comes true this year, we are in for some robust gains, as stocks just enjoyed the strongest January since 1987 (when it rose +13.2%). For the full month of January, the S&P 500 gained +8.0% (and S&P mid and small caps were even stronger at around +10.5%). Meanwhile, after a dismal 2H2018 in which Sabrient’s cyclicals-heavy portfolios trailed the broad market in the wake of a fear-driven defensive rotation that began in June, our 12 monthly all-cap Baker’s Dozen portfolios from 2018 handily outperformed by gaining an average of +11.8% for the full month of January (and +19.7% since the low on Christmas Eve through 1/31, versus +15.2% for the SPY), and our actively-managed SMA portfolio (which holds 30 GARP stocks) gained +13.2%. Fundamentals seem to matter again, and institutional fund managers and corporate insiders have been suddenly scooping up shares of attractive-but-neglected companies in what they evidently see as a welcome buying opportunity.

On the other hand, it’s pretty clear to me that 4Q2018 was unnecessarily weak, with the ugliest December since the Great Depression, selling off to valuations that seem more reflective of an imminent global recession and Treasury yields of 5%. So, some might argue that January’s big rally was just a temporary bounce from massively oversold conditions – a case of “righting the ship” back to more appropriate valuations – and as such is giving us a little indication about the balance of the year.

My view is more on the bullish side. When you combine earnings beats and stable or rising forward guidance with price declines, it sure seems to me that the worst is behind us, as investors recognize the opportunities before them and pay less attention to the gloomy news headlines and fearmongering commentators. Moreover, I expect to see a renewed appreciation for active management and a return to a more selective stock-picker’s market, with a rising stock market fueled by a de-escalation (or preliminary resolution) to the trade war with China and a more patient and accommodative Fed. In fact, as I said at the start of the year, I think the S&P 500 will finish the year with a gain in the 20-25% range – but savvy stock selection could produce even better returns. However, please be cognizant of 2018’s lesson that volatility is not dead, so try not to be alarmed when we encounter bouts of it over the course of the year.

Market Commentary:

The gloomy investor sentiment last year was primarily due to the escalating trade war with China and the Federal Reserve seemingly hellbent on raising rates and withdrawing liquidity from the financial system. This led to a defensive risk-off rotation in June and ultimately to the worst year for stocks since 2008. But throughout a rough 2H2018, the consensus positive outlook among the analyst community really hadn’t changed much. Yes, the forward P/E of the S&P 500 was destined to come down from the 18.5x level it displayed at the start of 2018, but falling all the way down to 13.6 in December was way overdone, in my view, given sub-3% interest rates and 10%+ expected earnings growth. To me, this was yet another case of investors ignoring the positive fundamentals – and historically such behavior has proven to be a transitory event, as stock prices over time eventually reflect fundamentals.

But that was little consolation for some of the brightest and most successful valuation-driven investors last year. David Einhorn of long/short Greenlight Capital said that “nothing went right” as his fund lost 34%. Cliff Asness of quant-based AQR Capital called 2018 a “George Costanza market,” in reference to the Seinfeld TV show episode in which George found success by doing everything the opposite of what he would normally do.

Indeed, holding smaller caps and cyclical stocks 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 at all in 2H2018. However, once the tax-loss selling exhausted itself on the Christmas Eve “capitulation day,” a V-shaped recovery launched, and January’s impressive performance served as an encouraging reminder that timeless growth-at-a-reasonable-price (GARP) investing is far from dead, as most of Sabrient’s portfolios have outperformed – many by a wide margin.

For the full month of January, the S&P 500 large caps (SPY) gained +8.0%, Nasdaq 100 (QQQ) +8.6%, S&P 600 small caps (SLY) +10.5%, and S&P 400 mid-caps (MDY) +10.6%. As for sector performance within the S&P 500 in January, S&P Dow Jones Indices reported that Industrials and Energy were the top-performing sectors at +11.4% and +11.1%, respectively, while Utilities and Healthcare were the worst at +3.4% and +4.8%. Oil gained 20% and is back up to $55/barrel. Interestingly, Real Estate was strong in January at +10.8%, but also was by far the best performer over the past 3 months (+8.4%) and second only to Utilities over the past year (+10.4%).

Again, after underperforming during a difficult 2H2018 in which investors ignored fundamentals, Sabrient’s 12 monthly all-cap Baker’s Dozen portfolios from 2018 gained an average of +11.8% for the full month of January. It’s no surprise to me why our cyclicals-heavy Baker’s Dozen portfolios would outperform. The table below shows for three sample portfolios (that have terminated or will soon terminate):  1) the attractive aggregate forward earnings expectations upon launch, 2) the earnings growth that actually occurred over the ensuing 12 months, and 3) how each portfolio’s forward P/E looks today. For example, the January portfolio launched with an expectation of 54% aggregate EPS growth while the actuals came in much better at nearly 76%, but at the same time the forward P/E fell from 20.3 at launch down to 12.6 today. In other words, the aggregate growth expectations of the portfolio upon launch came in nearly 40% better while the forward P/E fell nearly 40%. That’s not the way it normally works when the companies you select produce even better than anticipated and maintain solid forward guidance.

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Disclosure: The author has no positions in stocks or ETFs mentioned.​

Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a ...

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Gary Anderson 7 months ago Contributor's comment

A cheery tariff optimism. The flaw is regarding the lifting of current tariffs. Trump has hinted he may not do so. Further, he is not going to lift steel tariffs. Forced technology transfers are not illegal. China may pass a law that may be lightly enforced making them illegal. That is hardly the biggest deal ever. We have American companies wanting access to China while they also want protection from China's superior and yet cheaper products. This is crazy.