Today is not a pretty day for the U.S. stock market in general as behemoth Apple (which has historically been a crowded position) is weighing on major indices following last night’s earnings disappointment. But the fact that the iPhone maker’s stock is the Dow’s worst performer so far this year is only a symptom of a wider issue that’s rattling U.S. equities right now. According to strategists at Bank of America Merrill Lynch, investors have been shunning most crowded positions this year as valuations become more important.
Long-term outlook for U.S. stocks is positive
Strategist Savita Subramanian and her team said in their U.S. Equity Strategy in Pictures report titled “The road to outperformance: keep it simple” that their models still suggest that there’s room for upside for U.S. stocks.
However, they warn that it could be months before things actually get better because of the growing heap of macroeconomic factors. They believe the majority of the high-yield rally’s drivers are now in the past and that the markets aren’t pricing in a Fed rate hike in June even though one is likely. And then there’s the upcoming EU referendum and the fact that we’re moving into what’s typically a seasonally weak time for oil prices, and both consumers and corporations are facing a great deal of uncertainty related to this year’s election.
The BAML team also warns that market volatility could increase as a result of tightening credit conditions and tumbling liquidity. They believe there’s a “significant” probability that the markets will re-test their recent lows, which could mean that the S&P 500 falls back under the 2,000 mark. They’re more bearish than most on the index and think it will sit at 2,000 at the end of the year.
Focus on free cash flow, growth
Subramanian and team said that after analyzing various investment strategies, they’ve come to the conclusion that investors just aren’t as enchanted with “special situations” as they were last year. They define “special situations” as events like spinoffs, activist campaigns, mergers and acquisitions and others. They said that instead, investors are starting to prefer growth and cash flow generation.
Today’s pullback in Apple stock demonstrates the preference for growth in a big way as the iPhone maker posted its first quarterly decline in years and the first-ever decline in iPhone units. The BAML team also noted the re-rating that’s been going on among cash-rich companies like Apple compared to their levered counterparts and that investors also are starting to prefer growth from free cash flow over credit-driven growth.
Cash flow over P/E
They also found that investors are beginning to care about valuations as momentum stocks have been among the biggest laggards this year while value stocks have been outperforming. They noted that investors are beginning to worry about earnings quality as well due to the widening chasm between pro forma and adjusted earnings, which is why free cash flow to enterprise value ratios being favored over price to earnings multiples. This growing gap throws P/E into question, and the BAML team advise investors to focus on companies with strong cash flow because this metric is “harder to fake.”
Additionally, they have found that stocks with higher FCF/ EV have brought bigger returns this year than all of the other valuation strategies they track.
Crowded positions over neglected stocks
Subramanian and team added that positioning is still driving returns as investors have started to shun crowded positions. In fact, their analysis indicates that among U.S. stocks, the 10 most crowded positions at the beginning of the year have underperformed the 10 “most neglected” by about seven percentage points, which they describe as “an atypically high spread.” They believe de-risking and outflows are driving this phenomenon.
The BAML team also warns that outflows might not let up any time soon as active funds saw their worst quarterly performance since they began keeping data. They added that active funds still hold the biggest share of large cap U.S. equity assets under management, and as a result, positioning will probably continue to be important. They boil down all their findings in this recommendation: that investors opt for “cheap stocks on free cash flow that are not widely held by the buyside. Here are the stocks that fit this suggestion:
All tables and graphs in this article are courtesy Bank of America Merrill Lynch.