Fed comments were about as expected, with a slight hawkish lean towards a steeper yield curve. Fed Funds are going to be near zero for the foreseeable future. They will continue to keep the shorter end of the yield curve under control until (realistically, a big IF) inflation gets above 2% for an extended period. Simply put, easy money is here to stay. So why did the major averages sell off into the close on Wednesday followed by another drop yesterday? Part of the answer lies in the construction of the indices, which are extremely overloaded with technology and growth stocks. The value and cyclical groups have actually been acting quite well recently. Higher long-term rates are bad for sky high P/E stocks.
The Nasdaq is already down 10% from its peak a couple of weeks ago. FANGMAN, on average, is down 15%. However, during this same period the Dow Jones Transportation index is positive, as are emerging markets. Banks, Materials and Industrials are flat. Gold, silver, copper and corn are solidly positive. Yields further out on the curve are up as well. Clearly, traditional value names are seeing inflows, while go-go growth stocks take it on the chin a bit after a staggering rally. Is this the end of the growth bull market?
The value vs. growth debate is not really a debate at all. Check out the value vs. growth chart below. Since the housing collapse in 2008, it has been all growth with brief spurts of value outperformance. This was preceded by the Y2K bubble popping and an eight year value leadership period. Since then, it has paid to own growth (Technology, Communication Services, certain pockets of Healthcare and online Consumer Discretionary). On the other hand, traditional value has been stuck in the mud (Energy, Industrials, Financials and Basic Materials).
The makeup of the S&P 500 is dramatically different today due to this outperformance. Let’s take a look at both periods to see where we were, where we are today and what we should expect going forward, starting with the value sectors.
Back in 2008, Energy had a 15.3% weighting in the S&P 500 versus just 2.3% in 2020, leading the value underperformance for a dozen years. This makes a lot of sense. Coal stocks are basically non-existent now. Exxon was once one of the largest companies in the world, but years of negative growth and declining prices have whacked this stock along with other major oil players. As oil goes the way of coal over the next decade+, this sector may have to be combined with Basic Materials. Other than tradable rallies when demand outstrips supply for a short period, this area is one with minimal prospects over the long haul.
Financials peaked in 2006, before a massive housing collapse. The sector had a 22.3% weighting in the S&P versus 10% today. Since then, yields have collapsed. Fifteen years ago, the 10-year Treasury yielded over 5%. Money market fund yields were 3%. PayPal# had 100 million users but they were basically tied to eBay#. That number is going to hit 400 million in short order. More importantly, PayPal is used everywhere. This is a critical sector if value is to start leading again. Fed intentions to keep short rates at zero for an extended period is good and bad news. Money market fund yields are nil today. Many banks still earn some fees on their funds, albeit on a declining scale. What they do need is higher long-term rates. The Fed can control the short-end but not the long. As they started to promote a higher level of acceptable inflation, the 30-year yield has jumped from 1.20% to 1.43%. Low, yes, but any breakout here and banks will benefit. By this time next year they will be allowed to buy back stock again. Today, a lot of banks carry 6-8 PE’s and 4%+ dividend yields. It is not crazy to think they could be big winners in a cyclical swap out of highly valued momentum names.
Industrials are a mixed bag and traditionally benefit from a rotation to value/cyclical exposure. This Sector weighting has declined as we have moved to a service economy, and many manufacturing jobs/plants have moved overseas. Industrials are down to 8.2% of the S&P after topping out near 12% in 2004. This area benefits from inflation, rising rates and the movement of goods. Higher food inflation drives farmer income. They buy more tractors and equipment. Rising real estate prices drives construction, which helps machinery purchases, both small and large. The market may be sniffing this out as Deere and Caterpillar set new annual highs again yesterday while the Nasdaq was down nearly 2%. The pulling forward of demand to have products shipped directly to homes has benefited UPS and FedEx# stock this year tremendously. An interesting sector to keep an eye on as we get back to normal life.
The 2nd largest sector weight in 2008 was Healthcare at 14.8% which is similar to today. Pharmaceutical stocks have been lagging, with biotech and equipment providers as the newly dominant players. Stock picking has been critical to success in this sector. Outside of the Covid beneficiaries, there isn’t likely to be much change from here. This sector has a broad mix of growth and value. They can win in both scenarios.
The big growth areas have obviously been in the Communication Services and Information Technology sectors. Hard to imagine, but Technology was only 15.3% of the index in 2008. Telecom, which is now Communication Services, was 3.8%. Today, they combine to a whopping 38.6% weighting. You may recall Technology was over 35% back in 2000 as well. Valuations are not as bad and ultra-low interest rates allow for some leeway. After seeing the latest tech IPO craziness of Snowflake, one can’t help but wonder if we’re near the end.
Snowflake is a cloud warehouse solution for analyzing big data, a critical and fast-growing segment. The company was valued at $12B after a round of private financing early this year. Their IPO this week was initially offered at $70. Institutional demand drove it to an official IPO price of $120. The first day of trading drove it to $319! This company, with $267 million in revenues last year, is now valued at $63B. Flashbacks to the dotcom era for certain. It is moves like this that get disciplined investors nervous. They are signs of the end of a bull market, not the beginning.
We don’t have the answers yet. The recent action in value/cyclical versus growth/momentum has occurred numerous times over the past 12+ years, only to be reversed. It does bear watching though. We haven’t seen valuations this extreme for a long time in growth land. Many world class companies in the cyclical arena are still reeling from Covid and trading at steep discounts relative to normalized earnings.
The next twelve months look better for a wider array of companies outside of the narrow list of winners this year. Ideally this is the start of a much broader expansion to this bull market. Time will tell. Growth stocks have pulled back to support levels which need to hold soon or the S&P could have more downside room. Other areas may keep rallying as funds look for a different home outside of 1% fixed income options.
Action could be wild today since it is quad witching day where market index futures, stock futures and options on both expire. Certain stocks will have wilder than normal intraday swings around expiration prices.
Lance Armstrong is 49 today. Actress Jada Pinkett Smith is 49 as well.