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Equity Perspectives

Without the tailwind of the U.S. Federal Reserve’s massive stimulus, broad market gains may be less likely. However, pockets of opportunity remain for investors who know where to look.

 

In Brief

  • Since the end of the U.S. Federal Reserve’s quantitative easing program in late 2014, U.S. equity markets have been essentially flat. As we enter the second quarter of 2016, what should investors be watching?
  • In examining equity returns, valuations, and corporate fundamentals, we see three important themes heading into the rest of 2016.
  • First, stocks in select high-growth sectors, and small-and mid-cap issues, may present opportunities.
  • Second, U.S. consumer spending could continue to strengthen.
  • Finally, investors may continue to emphasize stocks of high-quality companies, and those that pay steady dividends.
  • The key takeaway—Should the U.S. recovery continue, and prove sustainable, a preference for growth equities may return as investor confidence strengthens.

 

Since the U.S. Federal Reserve (Fed) ended its quantitative easing (QE) program in November 2014, followed by a rather restrained interest-rate “liftoff” in Decmeber 2015, U.S. equity markets have been essentially flat through the first calendar quarter of 2016, with a return to more normal volatility. But that go-nowhere performance masks some of the sharp swings that have occurred since the Fed ended QE, particularly during the most recent quarter. The S&P 500® Index, for example, started 2016 with a sharp sell-off, driven largely by fears of a “hard” landing in China (echoing last summer’s big decline in the Shanghai Stock Exchange) combined with uncertainty over interest-rate policy in the United States. The S&P 500 was down 12% at one point (as of February 11) amid fears that the United States might return to recession. Those fears abated late in the quarter, as leading indicators and labor market data affirmed that U.S. consumer spending remained relatively healthy. This affirmation, along with a more dovish posture from the Fed, helped the S&P 500 rally 12.5% by quarter-end, with the index just 3% off its record high reached last year.1

With the second quarter just underway, what might the U.S. stock market do for an encore? Digging into equity returns, valuations, and corporate fundamentals, we see three important themes heading into the rest of 2016:

1) Risk assets may be on sale.
First, our general view is that while the “easy money” has been made during the unprecedented period of QE by the Fed, there are, we believe, distinct pockets of opportunity in the equity markets, requiring investors to be more selective. For instance, identifying the next group of disruptive, transformative companies (such as the so-called “FANG” stocks of 2015) that have the potential to deliver outsized growth, despite a slow-moving U.S. economy, is one place to start. Innovation in secular growth industries, such as biotechnology, cloud software, and e-commerce, continues to thrive, fundamentally speaking, despite a sluggish economy and the fact that stocks in those sectors have been sold off in recent months. 

Also, small- and mid-cap stocks appear underappreciated in a market where investor preferences have favored the durability of mega-cap stocks. It’s worth pointing out that since the end of QE, the trailing P/E ratio of the Russell 2000 Growth Index, which represents smaller-cap U.S. stocks, has declined 17%, compared to a slight increase in the trailing P/E of the Russell Top 200 Index, a proxy for the largest companies in the United States.2 (See Chart 1.) That disparity highlights a clear preference for the safety of mature companies among investors and their continued risk aversion. It also raises the specter that if a bubble in these supposed “safety stocks” is developing, we eventually should see a reversal of fortunes as investor confidence strengthens.

 

Chart 1. A Post–Quantitative Easing Retreat from Smaller Caps May Be Creating Opportunity
Change in trailing price-to-earnings ratio of indicated indexes, June 30, 2014–February 29, 2016

Source: FactSet.
Past performance is not a reliable indicator or a guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results.
Indexes are unmanaged, do not reflect deduction of fees and expenses and are not available for direct investment.

 

2) The resilient consumer pulls the economy through.
Despite the growth of gross domestic product (GDP), the U.S. consumer is demonstrating resilience, and may be strengthening. In March, we saw the sixth consecutive month of increases in the labor market-participation rate, based on data from the U.S. Bureau of Labor Statistics, a phenomenon that eluded the first six years of the current U.S. recovery (see Chart 2). In addition, the housing market continued to exhibit strength, as did monthly nonfarm payrolls data. Improvement in the labor market suggests that U.S. GDP—of which nearly 70% is driven by consumer spending—is likely not to turn negative.  

 

Chart 2. An Inflection Point for U.S. Labor Market Participation?
U.S. civilian labor force participation rate (in percent), January 2006–January 2016

Source: U.S. Bureau of Labor Statistics.
 

3) Dividends and durability remain highly prized.
That said, overall U.S. economic growth likely will remain sluggish, as severe weakness in the energy sector continues to weigh on corporate earnings and decelerating global growth puts pressure on U.S. exports. These factors, along with election-year uncertainty, may dampen investor sentiment. As a result, the preference for “dividends and durability” could continue into the fall. Since late summer 2015, the disparity in performance between mega-cap stocks and small-cap stocks has deepened, as has the gap between high-dividend payers and non-payers. Chart 3 illustrates general risk aversion in the equity markets thus far in 2016, where durability and predictability of earnings is preferred over the prospects for higher growth.

Dividends remain an attraction for staying invested during uncertain times, though the need for selectivity here is paramount, in our view, as the hunt for yield has created bubbles in some low-growth stocks and industries.

 

Chart 3. Safety First: Dividend-Paying and Mega-Cap Stocks Have Outperformed
Percentage moves for indicated equity indexes and exchange-traded funds for 2016 (through April 6)

Source: Bloomberg. Large-cap stocks represented by the S&P 500 Index. Small-cap stocks represented by the Russell 2000 Index. Mega-cap stocks represented by the Vanguard Mega-Cap ETF. High-yielding dividend stocks represented by the Vanguard High Dividend Yield ETF. Dividend-growth stocks represented by the SPDR S&P Dividend (ETF).
Past performance is not a reliable indicator or a guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.
Indexes are unmanaged, do not reflect deduction of fees and expenses and are not available for direct investment.

 

One key question to consider, however, is just how long this disparity might last. Should the U.S. recovery continue to gather strength, a preference for growth equities may return. However, without the tailwind of the Fed’s QE, that economic improvement will need to be truly organic, and self-sustaining, for any “risk on” sentiment to take hold for the balance of 2016.
 

1Source: Bloomberg (for all index performance data).
2Source: FactSet.

ABOUT THE AUTHOR

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