Market Dynamics in Two Graphs

Perspective
Written by J. Cannon Carr, Jr., Jeffrey P. Moeller, CFA on July 9, 2018

What do the market winners look like mid-way through 2018? Using our database, which captures millions of financial records on thousands of individual stocks, we answer that question with two graphs.

First: It’s All about Stocks with High Momentum

This first graph shows the returns through June 30 for the most common investment strategies (e.g., Value, Growth, Momentum, Quality, Low Volatility, etc.). A few noteworthy points:

  • The current market is dominated by Stock Price Momentum, long-term forecasted earnings growth, and earnings momentum. Momentum can work as a strategy, but we are concerned that there’s little deep fundamental support for the current rally aside from high expectations about future earnings growth—which often end up being too optimistic, by our research.
  • Stocks that are “cheap” or “on sale” relative to their fundamentals (“Value” stocks) are generating the worst returns this year. This runs counter to longer term trends. For example, according to Morningstar, an independent research firm, Value has generated better annualized risk-adjusted returns compared to Growth from 1970 to 2017[1].
  • We predominantly follow the Value style, so it is not a surprise that the year-to-date returns for stocks that we rate a “sell” are beating those that we rate a “buy” in our research system (the top two bars in the graph).

Despite the momentum in tech and other stocks with high growth outlooks, we believe there is no reason to abandon the Value philosophy.

Investment Style Returns

 

Second: This Year’s Winners are the Most Expensive—and Getting More Expensive

This next graph underscores a similar message, but from a different angle. It shows returns for stocks according to their current P/E multiples[2] through June 30, by decile. Stocks with P/Es in the first decile are the cheapest, and stocks in the tenth are the most expensive.

This graph shows that:

  • Stocks with the most expensive valuations (those in deciles 9 and 10) are generating the best returns this year by far. Excluding those selected stocks, broader market returns are far worse.
  • Stocks in decile 10 have P/Es of over 50x earnings (or have negative earnings), and as much as 277x. For comparison, stocks in decile 1 have P/Es averaging 10x earnings—a more attractive position for the long-term, in our view.
  • Incidentally, stocks in deciles 9 and 10 are the most heavily “shorted” (by a factor of 2:1, by our research)—which means investors have taken negative bets on them. The fact that these stocks generated some of the best returns over the past three months indicates much of this rally may indeed be “short covering”—whereby investors taking negative bets are forced to close those bets by buying shares. A short-covering rally is not a strong fundamental sign, in our view.

What stocks make up deciles 9 and 10? Currently, those deciles are skewed to tech, retail, and energy.

Returns by P/E

Bottom Line

The market this year is challenging. Success means picking very specific sectors and stocks, most of which are very expensive and often don’t have the best fundamentals. Our method often underperforms in this kind of market. Many managers and hedge funds are struggling this year, but that isn’t much consolation.

In 2017, even with Value out of favor, CornerCap's large cap value strategy was able to keep up with the S&P 500 due to our fundamental tilt toward earnings improvement and screen against weak growers. So far this year, such tilt did not help, as valuation is so out of favor. Growth is simply not at a reasonable price, by our definition.

For the long term investor, low multiple stocks are always discounted for sale.  As in past bull markets, the “low P/E” stocks appear dull and boring, even as the highest P/E stocks appear to be either more exciting, or the only “sources of growth”. We have seen challenging markets many times before and remain confident in our long-term discipline for generating solid returns.

Disclosure: Past performance is no guarantee of future results, and all investments are subject to risk of loss.




[1] Source: Morningstar. Growth and value stocks in this example are represented by the Ibbotson Associates Growth and Value Indexes for 1970–1997 and the Morningstar Style Indexes thereafter. Ibbotson Associates Growth and Value Indexes calculated based on data from CRSP US Stock Database and CRSP US Indices Database, Center for Research in Security Prices (CRSP®), The University of Chicago Booth School of Business.

[2] “Current P/E” is Price-to-Earnings for the past 12 months, a common metric for the Value investment style.

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