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Are you positioned for the post Great Rotation era?

Summary:
Is the US stock market in a bubble? Yes and no, according to Ray Dalio of Bridgewater Associates. Using a proprietary technique to create a “bubble indicator”, Dalio concluded that “the aggregate bubble gauge is around the 77th percentile today”, compared to a 100th percentile reading in 1929 and 2000.  Dalio qualified his analysis with some parts of the market are indeed very bubbly, but others are not. There is a very big divergence in the readings across stocks. Some stocks are, by these measures, in extreme bubbles (particularly emerging technology companies), while some stocks are not in bubbles.  Credit Suisse came to a similar conclusion with their US Exuberance Index. The number of companies with price-to-sales over 10 have surged, but readings are not at the levels seen

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Is the US stock market in a bubble? Yes and no, according to Ray Dalio of Bridgewater Associates. Using a proprietary technique to create a “bubble indicator”, Dalio concluded that “the aggregate bubble gauge is around the 77th percentile today”, compared to a 100th percentile reading in 1929 and 2000.
 

Are you positioned for the post Great Rotation era?
Dalio qualified his analysis with some parts of the market are indeed very bubbly, but others are not.

There is a very big divergence in the readings across stocks. Some stocks are, by these measures, in extreme bubbles (particularly emerging technology companies), while some stocks are not in bubbles. 

Credit Suisse came to a similar conclusion with their US Exuberance Index. The number of companies with price-to-sales over 10 have surged, but readings are not at the levels seen during the dot-com peak.
Are you positioned for the post Great Rotation era?
At the same time, the market is undergoing a secular shift from growth to value. Here are some important implications for investor portfolios in the next market cycle.

A (sort of) frothy market

While the US equity market is looking frothy, the amount of exuberance is limited to certain parts of the market. Bridgewater calculated the required earnings growth rate for stocks to justify current bond yields, and found levels are at the 77th percentile of historical observations. 
Are you positioned for the post Great Rotation era?
While the exuberance during the dot-com era permeated all parts of the market, the enthusiasm has been largely limited to the public pricing of equities. This time, corporate management is not responding with capital spending and M&A plans based on sky-high expectations.
One perspective on whether expectations have become overly optimistic comes from looking at forward purchases. We apply this gauge to all markets and find it particularly helpful in commodity and real estate markets where forward purchases are most clear. In the equity markets we look at indicators like capital expenditure—whether businesses (and, to a lesser extent, the government) are investing a lot or a little in infrastructure, factories, etc. It reflects whether businesses are extrapolating current demand into strong demand growth going forward. This gauge is the weakest across all our bubble gauges, pulling down the aggregate read. Corporations are the most important entity in terms of driving this piece via capex and M&A. Today aggregate corporate capex has fallen in line with the virus-driven hit to demand, while certain digital economy players have managed to maintain their levels of investment. Similarly levels of M&A activity remain subdued so far.
Are you positioned for the post Great Rotation era?

P/E compression ahead

In light of the secular rotation from growth to value, here are some important market implications for investors.
Are you positioned for the post Great Rotation era?
First, get ready for P/E compression. The analysis of the S&P 500 for YTD 2021 shows that gains were attributable to rising earnings expectations, while P/E ratios fell.
Are you positioned for the post Great Rotation era?
Fortunately, forward earnings estimates have been rising steeply across all market cap bands, with small caps the strongest of all.
Are you positioned for the post Great Rotation era?
On the other hand, forward P/E are likely to compress as inflation expectations rise. However, investors need to distinguish between reflationary forces, which are reflective of positive real economic growth and equity bullish, and inflation, which leads to central bank tightening and equity bearish. As I pointed out last week, the current tactical narrative is reflation (see Will rising yields sideswipe equities?).
Are you positioned for the post Great Rotation era?
For investors, this has a number of important portfolio positioning implications.
  • Avoid the high-flying growth bubbly growth stocks.
  • Focus on the value parts of the market.
  • Focus on the parts of the market exhibiting better earnings growth, such as mid and small-caps.
  • Focus on non-US markets, which are trading lower forward P/E ratios than the US. With Big Tech comprising nearly half of the weight of the S&P 500, the US P/E premium to the rest of the world is becoming overly stretched and due for some mean reversion.
Are you positioned for the post Great Rotation era?

Portfolio construction: Structural changes in stock-bond correlations

The other portfolio implication is the changing nature of the stock-bond correlation. In his latest letter to Berkshire Hathaway shareholders, Warren Buffett warned about the current level of yields and joined the chorus about the “bleak future” for fixed-income investors.
And bonds are not the place to be these days. Can you believe that the income recently available from a 10-year U.S. Treasury bond – the yield was 0.93% at yearend – had fallen 94% from the 15.8% yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt. Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.
As inflationary pressures heat up in the next market cycle, the low to negative stock-bond price correlation experienced since the late 1990’s is going to change. (Note that the chart below shows stock to Treasury yield correlation, and bond prices move inversely to yields).
Are you positioned for the post Great Rotation era?
If history is any guide, the shift from growth to value will also mean a rising stock-bond correlation.
Are you positioned for the post Great Rotation era?
This has important considerations for portfolio construction and investment strategy. No longer can investors expect a low or negative correlation between stocks and bonds. While fixed-income holdings will still be diversifying in a balanced portfolio, they are far less likely to act as ballast if stock prices fall. Investors holding the traditional 60% stock and 40% bond portfolio should therefore expect higher volatility. The latest historical study from Credit Suisse shows that the drawdowns from a 50/50 portfolio were significantly higher during the period of high stock-bond correlations.
Are you positioned for the post Great Rotation era?
In addition, the underlying assumption of portfolio strategies that depend on low and negative stock-bond correlation such as risk-parity will face considerable difficulty. Bloomberg recently documented the headwinds faced by risk-parity funds.
Are you positioned for the post Great Rotation era?
Risk-parity and other volatility targeting strategies employ leverage to achieve their risk-adjusted returns. While current levels of leverage are relatively low and lessen the risk of a disorderly unwind of positions, the longer-term outlook for such strategies depends on assumptions about asset return correlation that may not exist under a regime change scenario.
Are you positioned for the post Great Rotation era?
Accounts that invest in such strategies should re-evaluate their long-term commitment to such funds.
In conclusion, a secular rotation from growth to value isn’t as simple as it sounds and has important implications for investor portfolios. From a stock selection perspective, investors should:
  • Avoid the high-flying growth bubbly growth stocks.
  • Focus on the value parts of the market.
  • Focus on the parts of the market exhibiting better earnings growth, such as mid and small-caps.
  • Focus on non-US markets, which are trading lower forward P/E ratios than the US. With Big Tech comprising nearly half of the weight of the S&P 500, the US P/E premium to the rest of the world is becoming overly stretched and due for some mean reversion.
From a portfolio constructive perspective, investors should be prepared for rising stock-bond correlations. While stock and bond holdings will still be diversifying, balanced portfolios with are expected to experience higher overall volatility, and volatility targeting strategies such as risk-parity will be less effective in achieving their objectives.
About Cam Hui
Cam Hui
Cam Hui has been professionally involved in the financial markets since 1985 in a variety of roles, both as an equity portfolio manager and as a sell-side analyst. He graduated with a degree in Computer Science from the University of British Columbia in 1980 and obtained his CFA Charter in 1989. He is left & right brained modeler of quantitative investment systems. Blogs at Humble Student of the Markets.

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