The S&P 500 Index is set to end 2017 on a high note, up around 22 percent for the year including dividends.
However, we believe a major sector rotation is underway.
For 2017, technology has been the big winner with the S&P 500 Information Technology Index up 39.25 percent this year, its strongest showing since 2009 when the market was just recovering from the Great Recession. Meanwhile, notable laggards include energy and telecom services, both down slightly for 2017.
Since summer, however, the picture has shifted. Since the end of August, the S&P 500 Energy Index is the market’s top performer, surging close to 17 percent while financials took the No. 2 spot, up more than 14 percent. Meanwhile, IT stocks performed in-line with the market average and have underperformed so far this month.
Over the past seven years, US investors have embraced so-called smart beta exchange traded funds (ETFs)–total assets under management have exploded more than five-fold from $131 billion in January 2012 to more than $700 billion today.
The basic premise behind smart beta funds is that certain fundamental stock characteristics–such as stock valuations, stock volatility, profitability (quality) and growth–correlate with performance over the long haul. And rather than weight portfolios by market capitalization (i.e., firm size), it makes more sense to weight the stocks in your portfolio on other fundamental factors.
Most importantly, different quantitative factors tend to perform best at different stages of the economic cycle.
Two of the most popular smart beta categories are value ETFs and growth ETFs. Value ones focus on stocks with low valuations, as measured by a variety of metrics including price-to-earnings, price-to-sales or price-to-book value. And growth funds favor stocks with strong earnings and revenue growth.
The monthly flows of assets into (or out of) value and growth ETFs over the past year reveal clear trends: In January and February 2017, value ETFs attracted the most inflows while growth ones took the driver’s seat from March through August, with total fund flows over this six-month period favoring growth by nearly 4-to-1.
Since summer the trend has flipped again, with value ETFs experiencing nearly $10 billion in inflows compared to just $3.3 billion for growth ETFs.
It’s crucial to remember that smart beta ETFs only represent the tip of the proverbial iceberg when it comes to fund flows into value and growth stocks. There are literally trillions of additional dollars invested in value or growth-focused mutual funds and hedge funds that use quantitative factors like growth and value as the basis for their investment strategies.
However, we believe flows in and out of smart beta ETFs reveals a great deal about underlying trends in the stock market.
The shift from value to growth ETFs is broadly driven by expectations for economic growth. Simply put, when investors believe the US economy is decelerating or growing at a lackluster pace, growth stocks have the edge since these companies are able to generate earnings and revenue growth without help from the broader economy and economic cycle. The most important growth sector in most funds is Information Technology.
In contrast, value stocks tend to be more cyclical names in industries like energy, materials and financials. These firms are more levered to the economic cycle and need the “push” from the broader economic environment to work out.
Thus, the shift in smart beta fund flows matches up neatly to the broader economic trends in 2017. Following the presidential election in late 2016, investors began to price in the potential for President Trump to follow through on election promises such as significant tax cuts and infrastructure spending plan.
Since these tend to driver stronger growth, stimulus favors value over growth stocks.
However, confidence in the new administration began to wane in the spring following the failure of early legislative efforts such as the drive to repeal and replace the Affordable Care Act (ACA). In addition, US first-quarter economic growth came in at a paltry 1.2 percent annualized pace.
Value surged back into favor after August when, first, tax reform began to gain momentum in Congress and, second, US economic growth showed signs of acceleration–both second- and third-quarter US GDP growth topped 3 percent, the first back-to-back quarters of 3-plus percent growth in roughly three years.
Our view remains that this sector rotation will continue into 2018 with growth-focused groups such as information technology taking a backseat to value-oriented fare like financials and energy and cyclical industry groups.
In this issue, we’re selling Cars.com (NYSE: CARS) for a roughly 20 percent total return.
The stock recently surged after activist investor Starboard Value purchased a 9.9 percent stake in the online auto marketplace, which is likely to push management to pursue a sale.
In addition, nearly one-third of the stock’s outstanding float is sold short. When a stock rallies, short sellers, betting on a decline in the stock, feel the pain. Major moves such as the recent run-up in Cars.com can ignite a short squeeze where those betting against the firm buy the stock to cover their shorts, putting more upside pressure on the stock and prompting yet more short covering.
Despite the recent surge, we believe Cars.com faces a significant competitive challenge from TrueCar (NSDQ: TRUE), which has added new features to its website and rolled out an aggressive marketing campaign to heighten awareness.
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