While economic anxiety has hit the market prior to the often bearish summer months, we continue to concentrate on matters less publicized: a shift in equity market leadership in favor of quality driven by rising interest rates.
A familiar old adage has it that one of the best ways to preserve capital in the stock market is to, “Sell in May and go away.” In fact, the recommendation that investors try to avoid the often bearish months of summer and fall may be the oldest market-timing strategy on record.
Regardless of its merits as an investment approach, we’ve been thinking of this old saying recently in the wake of the market’s behavior.
So far in 2014 we have seen a weakened U.S. dollar, ongoing frustration with the slow rate of growth in our economy, GDP still struggling to notch a rate that would signal a truly robust expansion, and global growth slowing.
In addition, the Barclays U.S. Aggregate Bond Index outperformed the major domestic stock indexes year-to-date through the end of April.
If this litany of anxieties sounds familiar, there are good reasons. For example, last May we wrote, “For a fourth year in a row, as the calendar turned from March to April, global growth was called into question, and the markets reacted… Corporations are struggling to generate top-line growth and investors are struggling to find yield.”
So 2014 would seem to mark the fifth consecutive year that equity investors have paused to ponder the state of the global economy and its effect on stock market valuations.
Many have opted to sell, no doubt concerned that the dynamic bull market that ran virtually correction-free through 2013 is about to, or already has, reached its peak.
To be sure, these are all legitimate concerns, but our attention is more fully engaged by developments that have been less well publicized.
For the last several years, our portfolios have been mostly underweighted in several areas that have at some point led the market: traditional bond proxies, such as REITs and MLPs; concept stocks that have no earnings or returns on capital, frequently from the biotech, internet, or software industries; and structurally indebted businesses, such as airlines and others involved in major transport.
And while the success of certain cyclical sectors (such as Energy) has been clear since the March 4, 2014 small-cap high, it’s also true that the origin of the market’s current shift goes back a bit further.
We have actively avoided many of these high-flying or high-yielding companies because they typically have not fit our exacting standard of attractively low valuations and strong business fundamentals.
Yet equity market leadership has recently undergone a tonal shift, particularly following the 2014 high for the small-cap Russell 2000 Index on March 4 and since the March 19 FOMC meeting during which Fed Chair Janet Yellen promised to raise rates “six months or so” following the end of tapering.
Since then, the market has turned once more to those more economically sensitive areas of the market, which are beginning to work after years of lagging their more defensive and/or fast-growing counterparts. And while the success of certain cyclical sectors (such as Energy) has been clear since the March 4, 2014 small-cap high, it’s also true that the origin of the market’s current shift goes back a bit further.
Looking at 12-month returns from the May 2, 2013 calendar low for the 10-year Treasury yield, which marked the beginning of a rising interest-rate environment, reveals some interesting results.
Many cyclicals in sectors such as Energy, Industrials, and Information Technology have improved over this year-long period on both an absolute basis and versus their more defensive peers.
This has been welcome news for us. Over the last five years, we have been more active in cyclical sectors, finding more companies in these areas with the balance sheet strength, free cash flow generation, and other signs of financial well-being that have traditionally populated our portfolios.
So far in 2014, the advice heeded by many investors looks as though it was, “Sell in March.” This raises the possibility that certain investors were expecting a correction two months sooner than the old saw would have it.
Whatever the outcome of the market’s latest bout of volatility, a few things seem clear to us—rising interest rates are here to stay, even if the increases come by fits and starts, and this is ushering in a more historically familiar environment for stocks, one that is already rewarding the kind of patient and disciplined stock selection that has always been a hallmark here at Royce.