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Market View

While economic growth remains sluggish, transformative innovation should continue to drive best-in-breed growth companies. 

Concerned about equities amid a persistently slow-growth U.S. economy? After a challenging first four months, 2016 has been marked by improved investor sentiment toward many rapidly growing, innovative companies and secular-growth stocks appear poised to regain market leadership. Greater clarity on policy once we clear the U.S. elections may also fuel a strong market, similar to the reaction following the 2012 elections.

“We believe a select group of innovative companies has the potential to deliver outsized gains as they realize outsized top-line and bottom-line growth even in a slow-growth economy,” said Thomas O’Halloran, Lord Abbett Partner and Portfolio Manager. Many of these companies have also benefited from the extraordinary monetary stimulus initiated around the world since the financial meltdown of 2008–09, and we believe a continued low interest-rate environment—even if modest increases come in the next few years —will continue to help them finance their growth.”

While stable, slower-growth stocks have performed well on a relative basis so far this year, O’Halloran expects that trend to reverse in favor of high-growth companies, given an abundance of investment opportunities, particularly in technology (e.g., cloud computing, information security and mobility), health care (biotechnology and cutting-edge medical devices), and e-commerce.

“Relentless innovation continues to create new industries and transform existing ones,” O’Halloran added. “The most innovative companies are disrupting the established economic order with new products and services that should enable them to grow at a significantly faster rate than that of the general economy, and sometimes for a long time.”

Big on Small Caps
Recapping the past year for small-cap growth stocks, Brian Foerster, Lord Abbett Equity Investment Strategist, acknowledged that the end of quantitative easing (QE) in the United States, fears of a hard landing in China, and a broad market earnings recession in the S&P 500® Index shifted investor preferences away from high-growth stocks toward stocks with lower earnings and price volatility and the potential for dividend income. But Foerster said stock-specific fundamentals have become important again for high-growth stocks after a period of valuation-driven selling.

“Broad-based investor risk aversion is still a concern; however, the threat of a U.S. recession has dissipated in recent months, and market sentiment toward small caps and growth stocks has improved markedly,” Foerster added.  “That clear shift can be a leading indicator that mid-cap and larger-cap high-growth names are in the early stages of a longer-term bull market in growth.”

Chart 1 illustrates this dramatic shift toward safety beginning in August of last year, when the fastest-growing companies (gold line) experienced a harsh sell-off between August and March and the slowest-growth companies in the benchmark (dark grey line) rallied by comparison. During the second and third quarters, however, we saw a statistically significant reversal of this trend, where high-growth stocks outperformed the Russell 2000 Growth Index since the end of April.

 

Chart 1.  High-Growth Stocks Have Returned to Prominence  



Source: Morningstar; data as of 09/30/2016. Past performance is no guarantee of future results.  For illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Core refers to the type of company in the Russell 2000 Growth Index that are considered core style by Morningstar (those for which neither value nor growth characteristics dominate).

 

Chart 2 compares rolling three-month returns of the two market segments during the same period. This chart illustrates the sharp and violent shift in market sentiment, particularly in early 2016. On a rolling three-month basis, the fastest-growing stocks underperformed the Russell 2000 Growth Index by around 1,500 basis points at their nadir.

 

Chart 2. Investor Sentiment Is Favoring Fastest Growth Stocks, Again


Source: Morningstar; data as of 09/30/2016. Past performance is no guarantee of future results.
Core refers to the type of company in the Russell 2000 Growth Index that are considered core style by Morningstar (those for which neither value nor growth characteristics dominate).

 

“We are encouraged by the recent signs of improvement, as well as data suggesting that high-growth stocks are regaining their status as leaders in the small-cap equity space,” O’Halloran noted. “May was the first month in which we saw a number of high-growth names come back into favor, and, in our opinion, that is an important inflection point for our portfolio. The market is reacting more positively to companies exhibiting fundamental strength. In short, fundamentals appear to be important again, and the pervasiveness of macroeconomic factors in the high-growth space has been dissipating.”

Seeking Secular Growth Opportunities Despite Economic Weakness
The overhang of weak economic growth is likely here with us for years to come, as excessive debt in the developed world, a slowing China— which had been the engine for half the world’s GDP growth for the past decade— and unfavorable demographics in the world’s largest countries all serve as structural headwinds for economic expansion. That being said, economic growth has not been correlated with equity market performance.

Clearly, markets can have robust economic growth and weak market returns. However, it is clear that since the end of QE, volatility has risen and the broad U.S. equity markets have been range-bound.

We believe this type of environment is likely to continue for the S&P 500, as broad-based earnings continue to underwhelm and the economy trends toward GDP growth of 1–2%. (See Table 1.)  But we also believe secular bull markets can thrive at the same time, as illustrated by how biotechs and Internet retail have experienced explosive growth in recent years.  (See Chart 3.)

 

Table 1.  Sluggish Economic Growth Is Likely to Continue


Source: Bureau of Economic Analysis, Bloomberg and FactSet. 1Real GDP  Growth year ove year as of 06/31/2016. Data are most recent available. The personal consumption expenditure (PCE) measure is the component statistic for consumption in gross domestic product  (GDP). It consists of the actual and imputed expenditures of households and includes data pertaining to durable and non-durable goods and services. It is essentially a measure of goods and services targeted towards individuals and consumed by individuals. PCE Inflation year-over-year as of 08/31/2016. Data available on a one month lag. 310-Year Treasury as of 09/30/2016.  Data are most recent available.  For Illustrative purposes only.

 

Chart 3.  Many Companies and Industries Are Bucking the Slow-Growth Trend1



Source: FactSet and Bloomberg.
Note: Historical data are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
1Based on holdings in the Russell 1000 Growth Index from 09/30/2011 through 09/30/2016. Data are most recent available.  For Illustrative purposes only.

 

This experience reflects the definition of secular growth—these are the types of companies that do not need strong economic growth to thrive and deliver outsized market returns as a result. Certainly it helps that we continue to see a low interest rate environment and inflation remains below 2% as represented by the PCE, but investing in innovation is unlike investing in the S&P 500.

“The key takeaway for investors is that we have emerged in recent months from a stark period for high-growth stocks—one where double-digit organic growth and strong fundamentals were not only ignored, but punished because of higher market valuations,“ noted Foerster. “For investors looking to diversify away from the broad equity market averages—which should be quite average looking ahead – and invest in the true growth engines of the U.S. economy, allocating to secular growth may be a valuable approach.”

Next week, we will look more deeply at some of these secular growth areas for investors opportunistically seeking growth in their overall portfolio.

 

Risks to Consider: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Historically speaking, growth and value investments tend to react differently during the economic cycle. Since value stocks are often cyclical in nature, they may benefit from the increased spending that usually occurs during an economic expansion. Growth stocks may also perform well during an expansion, but they may also be out of favor during market downturns, when investors pay more attention to price ratios. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. No investing strategy can overcome all market volatility or guarantee future results.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

The Russell 2000® Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

The Russell 1000® Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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