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Market View

An improving fundamental backdrop could herald a revival of secular growth stocks and the potential for a sharp increase in the earnings power of many cyclical growth stocks. 

With broad U.S. equity market averages near all-time highs, many investors are fearful of an inevitable (so they believe) market decline after a big run for the markets off the bottom of the financial crisis in 2009. What is the most notable reason given for a sell-off? Valuations. And for some segments of the equity market today, we couldn’t agree more: there is reason for concern. But what’s perhaps most interesting is that the reaction of many investors is to resort to the “safety” of bond-like equities, which have in recent years become the most richly priced stocks. 

So, are we due for a valuation-centered pullback? Certainly, trying to time the equity markets is an exercise in futility. However, when thinking about whether the entire market is overvalued, fully valued, undervalued, etc., we think it is important, first, to break the tendency for investors to view equities as one big homogenous collection of stocks that all move in tandem. Second, with interest rates still far below anything resembling “normal,” the U.S. Federal Reserve’s (Fed) “Fed model” (which compares the stock market’s earnings yield to the yield on long-term government bonds) and other valuation metrics could still suggest that equities are, in fact, undervalued.  In fact, we believe a change in expectations for economic growth and interest rates—even modest ones—could have a significant effect on which stocks lead the market going forward and which ones could be hurt the most.

A Return to Secular Growth and the Potential for Cyclicals

As quantitative easing (QE) provided a big put option under the equity market, we witnessed widespread buying, with less regard for fundamentals such as sales growth or valuations. And when investors became anxious about the market in, for example, 2011, early 2014, 2015, and early 2016, their fear guided them to low-earnings volatility, high-yielding bond proxies such as telecoms, utilities, and some consumer staples stocks. In hindsight, the big winners of the QE era were mega-caps and bond-like equities. This trade became as massive as QE itself. Today, though, we see signs that this phenomenon could be coming to an end, for three reasons:

  • The end of the corporate earnings recession and signs of increasing capital expenditure investment and mergers and acquisitions
  • The potential for a higher-rate environment
  • The potential for government investment and fiscal stimulus

These factors could combine to shift the economic recovery from a monetary stimulus bailout to true acceleration in economic growth, which translates into a market where revenue and earnings growth once again matter much more than dividend yields. And if we are now in the process of moving from a monetary stimulus-led recovery to an earnings-driven market, it is likely that there will be a wider dispersion of returns between winners and losers. 

In such an environment, we believe stocks with high-growth characteristics could very well be the big winners. Areas such as biotechnology continue to thrive, with double-digit revenue and earnings growth, but have had middling performance in recent years due to a valuation correction from their bull run from 2010-14 and the political risks the sector gave rise to as a result of negative headlines about drug pricing and a tumultuous election cycle where price regulation became a chief concern. Similarly, the cloud software sector suffered severe declines last year despite no pause in that industry’s growth trajectory.  There are many examples of innovation being ignored to instead chase equity yield, and that is a trend some growth investors believe could reverse dramatically.

In addition, as we’ve written in the past, there has been severe weight on many economically sensitive areas of the market over the past decade—and for good reason. High tax rates, high regulation costs, and extraordinarily low interest rates kept most financials from growing at all, while lack of infrastructure investment prevented many industrials and materials companies from growing. Should at least some of the new policy proposals in Washington, D.C., come to fruition in the next one to two years, we also could see a sharp increase in the earnings potential of many cyclical growth stocks.

If the Economy Awakens, It May Be Time to Reduce the Bond Proxy Exposure

One potential area of concern for investors, though, may be the “bond proxy” sectors. We have noted in the past that the major growth index, the Russell 1000 Growth Index, contains several companies in its top 20 holdings that exhibit little actual growth. This is due to the fact that many indexes define growth as the absence of value, and in an unfamiliar environment where money markets and government bonds have yielded next to nothing, investors' behavoir has squeezed much of the value out of many stocks with little actual growth but temptingly high dividend yields.

These are not, however, your blue-chip dividend payers or time-tested dividend growers. These are stocks of entities like electric companies, cigarette manufacturers, some high-yielding real estate investment trusts, and telecom providers. They don’t grow much in terms of revenues, and, in fact, many are experiencing declining sales. Further, many have not been in the growth mode of their lifecycle for decades now, and many are in secular stagnation or decline. Their dividend yield is pretty much the lone attraction for investors; but in an era of persistently low bond yields, that criteria alone made them attractive enough to buy. And they were bought—heavily.

 

Table 1.  P/E Ratios Show a Clear Distortion of the Marketplace
Data for selected sectors of the S&P 500® Index, years ended December 31, 2010-16

Source: FactSet. 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 the deduction of fees or expenses, and are not available for direct investment. Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
Past performance is no guarantee of future results.

 

Focus on Growth

When looking at Table 1, and noting that the price-to-earnings (P/E) ratios for certain sectors with little historical or potential future sales growth has expanded to roughly the same levels as secular growth sectors (such as health care, information technology, and consumer discretionary), we see a clear distortion of the market. The important point to remember from this quick analysis is a fairly simple concept: equities are not bonds but rather the securitized equity slice of the corporate structure. If a company is rapidly increasing its sales and earnings, shareholders should benefit. And as dull and boring and seemingly safe as a utility stock may seem—given the low volatility of the company’s earnings, when it is trading at nearly twice its historical valuation—there is substantial downside risk when investor sentiment turns to focusing on earnings growth and away from simply yield. And as Chart 1 illustrates, secular and cyclical growth sectors, such as financials, materials, and information technology, are projected to set the pace for earnings growth in 2017.

 

Chart 1. Growth Sectors May Benefit from Earnings Growth
Projections of earnings growth of key sectors of S&P 500 Index, calendar year 2017

Source: FactSet Earnings Insight. 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 the deduction of fees or expenses, and are not available for direct investment. Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
Past performance is no guarantee of future results.

 

In sum, we see the potential for a fertile environment for true growth investing, where the winners and those gaining share within their industries may be rewarded. In our view, investor activity over the past few years has distorted the market by pumping up certain areas of the market based on stimulative monetary policy and a global search for yield. Secular growth stocks have been overlooked, and there may be substantial upside in these stocks. Moreover, among cyclical sectors, there could be upside should we see even a modest improvement in economic growth as well as a normalization of interest rates. 

 

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The Lord Abbett Growth Leaders Fund Class A seeks to deliver long-term growth of capital by investing primarily in stocks of U.S. companies. Learn more.
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