A View Of A Post-Fed Landscape by Heartland Advisors

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“Uncertainty is the friend of the buyer of long-term values.” – Warren Buffett

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Watching the volatility of the past few quarters, Buffett’s words are a reminder of the power of persevering through an economy distorted by Fed policy.

This era of Central Bank activism has been unprecedented. Domestically, the size, length, and warping effects of Fed policy has made its impact on markets. Bloated corporate debt levels and investor willingness to pay up for yield are just two consequences. Value stocks, small-caps in particular, have taken the brunt of pain with the average name in the Russell 2000® Value Index falling almost 25% from its 52 week high.*

Now, more than nine years into the Fed's efforts to inflate risk assets, the effects are beginning to wane. The fading influence of central banks around the world is playing out like the end of other asset bubbles—with short bursts of market volatility, sharp reversals in sector leadership, and gyrating commodity prices. The swings reflect uncertainty about whether the economy can stand on its own without intervention from the Fed. That question may not be answered in the near-term, but the markets seem to be betting yes. During the quarter, stocks in Materials and Industrials were strong performers, pointing to optimism for additional growth.

Changing weather. Turmoil during the past few quarters has tested investor resolve. We see it as the storm before the calm that will bring with it a return to rationality. Historic trends and recent moves in indices combine to heighten our optimism. As we’ve noted over the past year, the valuation disparity appears unsustainable. Momentum stocks are a clear example of the excess. As shown, the gap between stocks that have been appreciating and those trading at compelling valuations has exploded in the past 9 months and is now at almost 15 points.

Post-Fed Landscape - Small-Cap Momentum vs. Value Stocks

Post-Fed Landscape

Source: Cornerstone Macro Portfolio Strategy Team, 12/31/1999 to 3/28/2016
Momentum and value stocks are represented by proprietary groupings of the highest price momentum stocks and stocks with the lowest enterprise value/sales ratio, respectively, within the S&P SmallCap 600 Index.
Past performance does not guarantee future results.

We believe this difference will be too great to ignore as growth prospects can no longer support these rich premiums. A look at recent data suggests that time may come sooner than later. After peaking in early January, momentum has been a detractor for the average name in the Russell 2000® Index. While it’s too early to say its influence is over, we are encouraged that the recent data breaks a streak that has been going on for more than three years. Value is also showing signs of a resurgence, outperforming growth in recent weeks.

If this trend continues, the impact could be significant. The downturn of 2008 shows how abruptly roles can reverse for momentum and value stocks.

Post-Fed Landscape - Momentum Returns Sink When Broader Markets Rise

Post-Fed Landscape

Source: Cornerstone Macro Portfolio Strategy Team and Russell®, 11/3/2008 to 1/15/2009
High and low momentum stocks are represented by the top and bottom quintiles of Cornerstone’s proprietary factor of 6-month price change for stocks within the Russell 2000® Index. The difference between the price performance for each quintile is then indexed to a base value of 100 as of 12/31/1994. Quintiles are rebalanced monthly. Past performance does not guarantee future results.

During this period of Fed-funded distortions we’ve continued to apply our bottom-up analysis in search of companies trading at compelling valuations with idiosyncratic catalysts for recognition.

Our portfolios have been upgraded with many holdings having lower debt levels, higher dividend yields, and less exposure to macro events than in the past. In our view, that’s the best way to capitalize on our value-based philosophy. As the tide turns, our portfolios should be well positioned to capitalize on the return to a market where valuations matter.

We thank you for your continued trust and confidence.