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Portfolio Update

Are We Melting Up?

By Elliott H. Gue, on Oct. 27, 2017

The US stock market continues to show impressive momentum with strength supported by firm US economic data. While the broader market remains overdue for a pullback and correction, stocks are entering the most seasonally strong time of year.

We continue to see new market leaders emerging to carry stocks higher and expect the upside momentum to carry through the year’s end.

For much of the summer, we had concerns about the sustainability of the rally due to steadily weakening breadth. Simply put, the modest rally in stocks between the end of May and the end of August–roughly 3 percent for the S&P 500 and 3.6 percent for the Nasdaq 100–was driven by a diminishing number of stocks and sectors.

In fact, by mid-August with the S&P 500 just 2 percent from all-time highs, only 49 percent of NYSE stocks were above their 200-day moving averages. Even as the market continued to hold up well in August, most US stocks were in downtrends.

In addition, small-capitalization stocks have severely underperformed the broader market throughput most of this year. The Russell 2000 Index was up just 3.7 percent through the end of August, compared to an 11.3 percent jump in the S&P 500 and a 23 percent jump in the Nasdaq 100.

While rallies driven by a small cadre of high-momentum names can persist for a time, such moves are unsustainable over the long term. Invariably. momentum in those market leaders will break, prompting a market correction.

However, the recent weak-breadth rally hasn’t resulted in a correction. Instead, there’s been a significant sector rotation in favor of value groups. Since the end of August, energy, basic materials, financials and industrials–laggards for much of 2017–assumed the mantle of market leadership. The S&P 500 Value Index has jumped 5.4 percent since the end of August, besting the S&P 500 Growth Index by roughly 180 basis points.

We believe this rotation will continue. In fact, we’ve looked for a shift in favor of value since the first quarter of 2017.

As a rule of thumb, growth stocks tend to outperform the broader market when US economic growth (and global growth) are lackluster or decelerating. The reason is that growth stocks–technology being a standout example–don’t need support from the broader economy to generate earnings and revenue growth.

In contrast, value groups–like energy, financials and industrials–tend to be far more economy sensitive. Such groups perform best when the broader economy is growing at a solid pace or accelerating. Recent economic data suggest the latter scenario for the US economy right now; accordingly, we expect value groups to emerge as market leaders over the coming months.

(Click to enlarge.)

The latest evidence an accelerating US economy is third-quarter Gross Domestic Product (GDP) growth. It’s annualized pace of growth is 3.0 percent, which is a significant jump from the expected 2.7 percent and despite disruptions from Hurricanes Harvey, Irma and Maria.

Strength in the third quarter was broad-based, including significant contributions from consumer spending and business investment.

The latter is key. Business spending is typically leveraged to confidence in the US economy. And it had been a drag on growth through the first half of 2016. A notable recovery since late last year provides additional confidence in the durability of the recovery and the rally.

And, just remember: In today’s market, quantitative factors, like long-term earnings growth, quality (based on metrics like Return on Equity), valuations, risk and momentum, drive trillions of dollars in investment flows. Thus, shifts in the focus of quant models from one factor to another–such as from growth to value or low quality to high quality–can drive massive institutional fund flows out of one group of stocks and into another.

For example, $933 billion is invested in quant-based hedge funds alone. That’s quite a change from just 2008, when the figure stood at $392 billion. When you consider that many hedge funds use leverage to magnify their returns, it’s not hard to see how a seemingly subtle shift from a growth-focused rally into a value-driven market can result in massive changes in market leadership.

While stocks are expensive based on most valuation metrics and the bull market in the S&P 500 is long in the tooth by any historical yardstick, bull markets have historically ended with a bang, not a whimper.

(Click to enlarge.)

Since 1937, there have been 12 bear markets in the S&P 500, defined as a total decline of 20 percent or more from a closing high (the peak of the bull market) to a closing low (trough of the bear market).

In the chart above, we show the average performance of the S&P 500 in the 500 final trading days (roughly two calendar years) prior to the peak of all 12 bull markets since 1937 and the first 250 days (1 year) of the ensuing bear markets. To make these cycles comparable, the chart uses percentage gains/losses starting 500 days before the top rather than the actual level of the stock market at the time.

In the 12 bull markets since 1937, the S&P 500 rallies an average of 48 percent in the final 500 days of a bull market (58 percent including dividends).

The pattern has been remarkably consistent over the years: The worst return for the market in the final 500 days of a bull market was 30 percent.

The best return in the final 500 days was 129 percent leading up to the 1937 top.

It’s become increasingly likely the US stock market is in one of these melt-up rally phases that could propel stocks far beyond valuation norms, and far higher than many pundits believe, in coming months.

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