Style: Growth / Value

Highlights BCA's U.S. Equity Strategy team would like to wish our clients a healthy, happy and prosperous New Year. Portfolio Strategy The growth vs. value style bias is due for a bounce, but beyond the near run, the outlook has become more balanced. Stick with a small vs. large cap bias for the time being, but get ready to book profits if domestic wage inflation continues to accelerate. Buy into the health care facilities sell-off. Value is surfacing as profit margin pressures subside. Recent Changes S&P 1500 Health Care Facilities - Boost to overweight today. Downgrade Alert Growth vs. Value - Downgrade alert. Table 1Sector Performance Returns (%) Feature Stocks look poised to maintain their momentum-fueled march higher into yearend, seemingly impervious to potential profit backlash from tightening monetary conditions, a more hawkish Fed and/or overheating sentiment. Sellers are holding back in anticipation of lower tax rates next year. In fact, our Composite Sentiment Gauge has surged to extremely bullish levels (Chart 1). This gauge comprises surveys of traders, individuals and investment professional sentiment. Overtly bullish readings have been a reliable contrary indication of building tactical risks, although not foolproof. The broad market has returned nearly 80%, excluding dividends, since the beginning of 2012, and over 5% since election night in November. Lately, earnings expectations have increased their contribution to the market's return, but the vast majority of the gains over the last five years can be explained by multiple expansion. Soaring median industry price/sales ratios are consistent with lopsidedly optimistic sentiment (Chart 1). Now that the Fed has signaled its intention to steadily raise interest rates in 2017, a critical question is whether profits can take over the reins from liquidity as the main market driver, at least partially validating the valuation increase? On this front, our confidence level is low. Profit margins are steadily narrowing. Our profit margin proxy is not signaling any imminent relief (Chart 2). With labor costs rising, faster sales are needed to halt the squeeze. But U.S. dollar appreciation is a significant headwind to top-line performance, given that 45% of sales come from abroad. As hedges fall off, the impact on 2017 revenue will become increasingly meaningful. Corporate debt levels are disturbingly high, in absolute terms and as a share of GDP (Chart 2, bottom panel). If borrowing costs continue to climb, then it will be hard for companies to turn expansionist, potentially offsetting any benefit from a reduced tax rate. Against this backdrop, it is difficult to envision a robust rebound in corporate profits. Our confidence level would be higher if monetary conditions were still reflationary. Instead, our Reflation Gauge (RG), a combination of oil prices, Treasury yields and the U.S. dollar, has plummeted at its fastest rate ever (Chart 3)! The speed and ferociousness of the plunge underscores the economic need for a massive and imminent fiscal offset. Chart 1Sentiment Is Overheating Chart 2Stiff Headwinds For The Corporate Sector Chart 3Reflation Is Dead The RG leads both equity sentiment and the U.S. Economic Surprise Index (ESI, Chart 3). If economic activity begins to disappoint in the coming months, i.e. before any meaningful fiscal stimulus arrives, there is a window of risk for the equity market because valuations will narrow as optimism fades, especially in those sectors that have gone vertical since the U.S. election. Keep in mind, last week we showed that typical Fed tightening cycles augur well for non-cyclical sector relative performance on a 12 and 24 month horizon. Surprisingly, financials and utilities have also managed to at least keep pace with the broad market, with cyclical sectors lagging behind overall market returns. The bottom line is that a number of objective indicators are signaling that the post-election rally will hit turbulence, perhaps in the first quarter of the New Year. Investors would be well served from a cyclical perspective to take advantage of value creation in defensive sectors while reaping any windfalls received in deep cyclical sectors. Will Growth Vs. Value Recover? The sudden surge in the financials and industrials sector has caused a sharp correction in the growth vs. value (G/V) share price ratio. The scope of the move has been both powerful and unnerving, catching many off guard, including us. Is this the start of a value renaissance after nearly eight years of growth stock dominance? History shows that sustained rotations into the value complex require validation from strengthening global economic growth. We have shown in previous research that G/V share price momentum is negatively correlated with the growth in durable goods orders, house prices and profits, i.e. when these variables accelerate, growth underperforms value. By virtue of the improvement in our global PMI composite (Chart 4), it would be easy to conclude that value stocks are coming back in vogue. Financials, energy and industrials account for over 50% of the value composite. These sectors only comprise roughly 15% of the growth benchmark. In addition, the technology sector weighs in at one third of the growth index, while representing only 8% of the value cohort. In addition, consumer discretionary and health care also represent about the same weight as technology in the growth composite, but only contribute about half that in the value index. It is no wonder that rising bond yields and hopes for a fiscal stimulus bonanza have triggered such a violent G/V reaction. While we are sympathetic to this view, extrapolating the last six weeks to continue over the next six months is dangerous. Much of the Treasury yield advance has been driven by inflation expectations. Global real yields are up, but not by as much as share prices have discounted (Chart 5). That is not surprising, as the soaring U.S. dollar is a deflationary force, and heralds a sharp rebound in the G/V ratio (Chart 5, top panel). Chart 4A Vicious Correction... Chart 5... That May Soon Reverse U.S. currency strength will make it difficult for developing economies to service large foreign debt obligations and could drain domestic liquidity if they are forced to sell foreign exchange reserves to defend their currencies. It is notable that EM capital spending is virtually nil in real terms, and their share prices are underperforming the global benchmark by a wide margin (Chart 5). Our Global Economic Diffusion Index has crested (Chart 5, shown inverted), perhaps picking up emerging market sluggishness. Unless the U.S. dollar begins to weaken, it is premature to forecast robust economic growth in the coming quarters, thereby raising some skepticism about the durability of the value stock rebound. The objective message from our Cyclical Macro Indicators for the growth vs. value style is slowly shifting from bullish to neutral, and the pricing power advantage no longer exists (Chart 6). However, the latter is an unwinding of the rate of change shock in the commodity complex rather than renewed demand-driven pricing power gains in the deep cyclical space. From a longer-term perspective, growth stocks should stay well supported by the increase in long-term earnings growth expectations (Chart 7). When the latter are rising, growth stocks tend to enjoy multiple expansion relative to value shares. Moreover, if equity volatility perks up on uncertainty over the path and pace of future fiscal policy and a more hawkish Fed, then growth stocks should receive another source of natural support. The VIX and G/V indices tend to correlate positively over time (Chart 7). Chart 6Mixed Signals Chart 7Structural Supports In sum, choosing value over growth is not a slam dunk, nor is forecasting a recovery to new highs in the G/V ratio given the large sector weightings discrepancies. Rather, a reflex rally in the G/V ratio is probable as post-election financials/industrials sector enthusiasm wanes, with a lateral move thereafter. Bottom Line: We will likely recommend moving to a neutral style bias over the coming weeks/months from our current growth vs. value stance, but expect to do so from a position of strength. A Revival In Small Business Animal Spirits? A broad-based and powerful rotation into small caps has occurred, as all the major small cap sectors have surged relative to their large cap counterparts (Chart 8), flattering our current stance. Small caps fit nicely into one of our overriding longer-term themes, namely favoring domestic over global industries. Small companies are typically domestically-geared regardless of geography, underscoring that if anti-globalization trends pick up steam, this theme could gain traction around the world. The potential for U.S. corporate tax cuts has provided another source of domestic company enthusiasm, because multinationals already have low effective tax rates. However, these developments are not assured, details remain scant, and chasing small cap relative performance on that basis alone could be a mistake from a tactical perspective. We have noted that we would recommend profit taking if evidence of a reversal in the small vs. large cap profit outlook materialized. Recent labor market and pricing power data are slightly worrying. The NFIB survey of the small business sector showed that planned labor compensation is still diverging markedly from the overall employment cost index (Chart 9, second panel). While reported price changes have also nudged higher, the discrepancy in labor cost gauges may be signaling that the massive profit margin gap between small and large companies will not be quick to close (Chart 9, bottom panel). Still, the overall NFIB survey was strong, and suggests that animal spirits in the small business sector may finally be reawakening (Chart 10, second panel). The latter may reflect an easing in worries about government red tape, excessive bureaucracy and health care costs. Chart 8Broad-based Small Cap Outperformance Chart 9Yellow Flag For Margins Chart 10Overbought, But Not Overvalued These sentiment shifts may allow extremely overbought technical conditions for the relative share price ratio to persist for a while longer (Chart 10, middle panel), particularly if the Trump honeymoon phase for the overall market lasts until early in the New Year. Importantly, there is no meaningful valuation roadblock at the moment (Chart 10). From a longer-term perspective, however, it is notable that the share price ratio is trading well above one standard deviation from its mean. Such a stretched technical level warns against getting too comfortable with small caps. In fact, the share price ratio is tracing out a pattern similar to the early-1980s (Chart 11), when it enjoyed a brief run to new highs in 1983 on the back of similar aspirations of meaningful fiscal thrust and as the U.S. dollar sprang higher. However, that surge was short-lived and in hindsight, was a blow-off top that marked the beginning of a massive underperformance phase. Chart 11The Big Picture Bottom Line: Stick with a small/large cap bias for now, but get ready to take profits if the relative profit margin outlook does not soon improve. Buy Into Health Care Facilities Weakness Rapid sub-surface market gyrations are creating attractive value in a number of areas, particularly in the defensive health care sector. In particular, we downshifted our view on the S&P health care facilities index at mid-year, because consumer spending on health care was decelerating, which favored moving into equities that paid for medical services (managed care) vs. those that provided them. While that trend remains intact, health care facilities stocks appear to be discounting an extreme scenario. The current concern is that the Affordable Care Act (ACA) will be repealed, leaving hospitals to foot the bill for uninsured patients. While such a scenario would potentially reverse the decline in the provision for doubtful accounts (PDA, Chart 12), a major profit margin support, the ACA is more likely to be reworked than repealed especially in the absence of a replacement plan. Importantly, there are other offsets. PDA follows the unemployment rate, which is signaling that the former will decline further. Hospital cost inflation is beginning to recede, led by drug costs (Chart 12). Physician services costs and inflation in other medical supplies is also subsiding. Health care facilities have also reduced capital spending in a bid to protect profit margins. Construction data show that hospitals have eased back on the throttle significantly (Chart 13). A shift to a profit margin preservation mentality is confirmed by the sharp reduction in headcount growth and decline in total wage inflation (Chart 13). Labor cost control provides another positive profit margin support, over and above the fillip from the reacceleration in hospital pricing power (Chart 13). Consumers are allocating an increasing portion of their spending to hospitals, which provides confidence that pricing power gains will stick. It would take massive earnings downgrades to validate the pessimism embedded in current valuations (Chart 14). Technical conditions argue that the sell-off is overshooting. The share price ratio has made new lows, but cyclical momentum is diverging positively. Given that this group is traditionally a strong U.S. dollar winner (Chart 14, top panel), there is scope for a playable relative performance rally in the coming six months. Chart 12Hospital Costs Are Easing... Chart 13... While Sales Improve Chart 14Dirt Cheap Bottom Line: Augment the S&P 1500 health care facilities index (BLBG: S15HCFA - HCA, UHS, WOOF, HLS, LPNT, SEM, SCAI, THC, ENSG, USPH, KND, CYH, QHC) to overweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Small cap stocks were hit harder than large caps in the weeks leading up to the election, as investors shed riskier assets. Fuel for this selling may persist in the near term, based on the readings from the latest NFIB survey of the small business sector. The survey was lackluster, and showed that small company margins may come under renewed pressure, based on the jump in the planned labor compensation survey. Nevertheless, we recommend riding out any additional volatility. Large companies are also contending with rising wage costs, and our relative profit margin proxy continues to grind higher, in favor of small caps. Given our domestic vs. global emphasis, the window for small cap outperformance remains open.

It's hard to make a case for attractive returns from any asset class over the next year. We dial down risk a bit but ending our overweight on junk bonds. Investors should pick up yield where they can but without taking excessive risk.

Our <i>Cyclical Indicator Update</i> reveals that a defensive portfolio strategy remains the best bet to navigate the crosscurrents of stagnant profit/economic growth yet abundant global liquidity.

Since downshifting from favoring growth over value to a neutral style bias at the beginning of this year, the growth/value (G/V) ratio has corrected sharply. While this recommendation shift was timely, at issue is whether a major cyclical trend change is underway, or if a resumption of the advance lies ahead, and/or another style switch is appropriate. Before making any decisions, it is critical to understand the driving forces behind the last few months' price action. Growth indexes have a hefty non-cyclical element compared with value benchmarks. In addition, growth is tech-heavy while value is dominated by financials. Thus, the rebound in cyclical sectors alongside the gentle depreciation in the U.S. dollar and oil price recovery provided a good reason for value-oriented stocks to rebound. However, that rally has not been accompanied by any real improvement in the global business cycle. Now that U.S. employment is starting to soften, concerns about the health of the expansion may broaden. Growth indices have a strong track record of outperformance when economic expectations are weak, as proxied by declining global government bond yields (shown inverted, top panel). The surge in the S&P dividend aristocrats index is also consistent with a safety bid rather than a return to 'risk on'. For these and other reasons outlined in yesterday's Weekly Report, we recommend returning to a growth vs. value bias.

Last week's soft employment report reinforced our defensive vs. cyclical portfolio bias, as firms appear to be slowing hiring in response to the broad-based profit squeeze. That is a plus for non-cyclical sectors, as defensive sector profits have steadily outperformed in the last two years, supporting share price outperformance. The opposite is true for cyclical sectors, notwithstanding the bounce earlier this year. At some point, the tide will turn in favor of cyclical sectors, but a number of factors argue against making such a leap of faith at the moment, please see the next Insight.

Economic disappointment will become the key theme in the second half of the year, driving a return to non-cyclical market leadership and a recovery in the growth vs. value ratio.

A number of factors triggered our downshift from a growth over value bent to a neutral style bias in late-January. Value has outperformed growth in 80% of broad equity bear markets since 1960, and in more than half of economic recessions. While neither outcome is assured, they have become much higher probabilities as credit conditions have tightened. Sector weightings also played a role, as growth indexes have nearly quadruple the tech sector exposure as value benchmarks, and more than double the consumer discretionary exposure. We are bearish on both sectors. The incentive to bet on growth stock outperformance from current premium valuation levels continues to diminish. Overall long-term S&P 500 earnings growth expectations have been pared back aggressively of late. Reduced confidence in the secular profit outlook is a headwind for overall valuations, but particularly for growth vs. value stocks. The chart shows that momentum in the G/V ratio closely follows trends in 5-year earnings growth expectations, and the current message is that the price ratio has hit a ceiling.

Growth stocks have trounced value indexes over the last few years. The bulk of our style Indicators signal that macro conditions are still tilted in favor of growth. As a reminder, growth indexes almost always move to a premium when economic growth declines, as is currently the case. Nonetheless, we are losing conviction in the ability of growth stocks to sustainably outperform from current levels, despite our downbeat view of global economic growth prospects. Comparing the genetic makeup of the growth and value benchmarks with our current sector positioning suggests extrapolating recent gains is becoming higher risk. Growth indexes have nearly quadruple the tech exposure of value indexes, at the 32% vs. 8%. Consumer discretionary, another underweight, represents 18% of growth indexes vs. 7% of value indexes. That is a 35% weighting difference from two sectors. Meanwhile, the defensive telecom services and utilities sectors are 10% of value exposure, but only 3% of growth benchmarks. Importantly, growth stocks have a checkered past once equity bear markets and/or recessions set in. Since 1960, value has outperformed in 80% of bear markets. Value has also outperformed in 5 out of the 8 recessions since that time. While neither recession nor bear market is guaranteed at the moment, both are becoming higher probabilities. Adding it all up, we are moving to neutral in our growth vs. value bias after a 10% gain. Please see yesterday's Weekly Report for more details.

An oversold bounce may be getting underway, but without a policy assist, it would be a rally to sell. Go to neutral in the growth vs. value trade and beware sub-surface weakness in the consumer discretionary sector.