“The dictionary is the only place where success comes before work.”
—Vince Lombardi
The lazy days of summer are just beginning, but for the markets, they’ve been going on for several years. Signs of indifference are widespread. For example, instead of rolling up their sleeves and doing the hard work of fundamental analysis, many investors have taken the path of least resistance and simply poured money into passive index funds and exchange traded funds (ETF). While these products may serve a role in an asset allocation strategy, we’d suggest current valuations leave them open to painful losses if, and when, an inevitable correction occurs.
Current low volatility for stocks, in our view, is another symptom of the lackadaisical route many are following. As shown below, the Chicago Board Options Exchange Volatility Index (VIX) has been shuffling along near historic lows for months. Levels like this often point to rampant group think where a single popular view spreads and no one stops to ask the hard questions—what happens when interest rates go up? Can big tech really grow fast enough to support current lofty valuations?
Many management teams, recognizing an effortless way to boost earnings, have taken to borrowing on the cheap to fund stock buybacks. With fewer shares outstanding, earnings can go up without any actual improvement in margins and sales. Thanks to an all-too-willing Federal Reserve Board that has flooded the economy with easy money, the low effort approach has been working—at least for now.
So what could bring an end to this current cycle? Here are a few things we are watching:
- Anemic gross domestic product growth points to earnings pressure going forward.
- Consumer debt levels that are at pre-financial crisis highs.
- A softer dollar that could trigger higher inflation and raise costs for businesses.
- The impact of elevated short-term interest rates, which could take a toll on highly leveraged companies.
These items could be a headwind for many companies but expensive growth names may be the ones with the most to lose. Based on current multiples, the market is pricing in growth for these businesses that outpaces even some of the most optimistic scenarios from analysts. That means the slightest earnings misstep could be magnified and result in significant pressure.
The future, in our view, is much brighter for reasonably valued companies. As growth/momentum begins to wilt under the weight of ever increasing expectations, value should once again attract investor attention. Additionally, many sensibly priced businesses are just beginning to see their earnings inflect and, therefore, will be building off a more manageable comparison base as opposed to trying to meet unrealistic projections. Put simply, we’d rather invest in businesses that have ample room to improve than those that have no room for error.
Here are a few more reasons for optimism:
- Housing is robust.
- Consumer confidence remains strong and small businesses are upbeat.
- Merger and acquisition activity appears to be heating up among smaller companies.
The mixture of good and bad, points to the need for doing the hard work of evaluating opportunities. We agree with Coach Lombardi’s words and would add that in investing, not only does work come before success but a lack of it often leads to losses.
Disclosure:
Past performance does not guarantee future results.
Investing involves risk, including the potential loss of principal. There is no guarantee that a particular investment strategy will be successful. Value investments are subject to the risk their intrinsic value may not be recognized by the broad market.
The statements and opinions expressed in this article are those of the presenter(s). Any discussion of investments and investment strategies represents the presenter’s views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. Any forecasts may not prove to be true. Economic predictions are based on estimates and are subject to change.
Growth and value investing each have unique risks and potential for rewards and may not be suitable for all investors. A growth investing strategy emphasizes capital appreciation and typically carries a higher risk of loss and potential reward than a value investing strategy; a value investing strategy emphasizes investments in companies believed to be undervalued.
Definitions: Buyback: the repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Chicago Board Options Exchange Market Volatility Index (VIX): is a popular measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market's expectation of stock market volatility over the next 30 day period. Earnings Per Share: is the portion of a company’s profit allocated to each outstanding share of common stock. Exchange Traded Fund (ETF): is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold. Passive Management: a style of management associated with mutual and exchange-traded funds (ETF) where a fund's portfolio mirrors a market index. Gross Domestic Product (GDP): is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis.
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