Welcome to a special edition of the BPO Capital Monthly Newsletter. This month’s commentary centered around the length (and somewhat lacking breadth) of the current ‘bull market’ and that the backdrop for “value” has been improving after years of trailing the glitter and excitement of “growth”. We thought it might be helpful to provide some market research from our partner – Bluestone Capital Management – and direct your attention to a recent article from Bloomberg [https://www.bloomberg.com/news/articles/2018-08-06/bull-cycle-shift-value-stocks-come-roaring-back-from-the-dead] as some support to our position. Many of the most famous and successful investors of all time (Warren Buffett, John Templeton, and Benjamin Graham, to name a few) are ardent value investors. Value stocks have had a good run, just not quite as good as growth stocks. Many of the conditions that have subdued value are generally temporary and may be making a turn for the better. As the Bloomberg article suggests, the setup for value is showing signs of improvement and we at BPO Capital believe ‘value’ will work and we do not expect the extra returns generated by buying stocks cheaply to disappear.
Enjoy the information and stay tuned (or contact us via email) for a value manager we have discovered that has handsomely and consistently outperformed the broad market and peer group …
Bluestone Capital Management
EARNINGS ARE UP, BUT TRADE WAR GETTING UGLY
FAST FACTS ABOUT TODAY’S ECONOMIC DATA:
* The trade war rhetoric is heating up, but so are S&P operating earnings.
* Our GDP model sees 3%+ growth through 2018 and then 2%+ growth in 2019.
Q2 S&P EARNINGS OFF TO RECORD START – BUT WILL A TRADE WAR DERAIL THE TREND?
Earnings are coming in better than expected, and our GDP model suggests that there are few headwinds for several more quarters to come. The biggest issue facing the markets may be the looming trade war with China. We aren’t sure what China’s strategy is here but it appears they are digging in for a fight. With Larry Kudlow saying over the weekend that “China better take President Trump seriously,” we must begin to ask ourselves just how bad this trade war might get.
The Trump Administration is now threatening 25% tariffs on basically every single product the U.S. imports from China. Meanwhile, China has allowed its currency to fall by 10% since April, which already softens the blow. It’s safe to assume that China’s currency will fall further as they have every incentive to do so given their weakening economy.
Meanwhile, U.S. based investors remain blessed with rising corporate earnings. As of August 3rd, 315 of the S&P 500 Index companies have reported Q2 earnings, of which 253 have beaten earnings (80.32%) and only 42 have missed (13.33%) earnings estimates. In fact, there are six sectors in which at least 87% of companies has beaten EPS estimates thus far. On the other hand, only 45% of Energy companies and 55% of Real Estate companies have beaten Q2 estimates. It is now more than half way through Q2 earnings season and all signs point to another record quarter.
EARNINGS SET FOR MORE RECORDS IN Q2 AND BEYOND:
Despite the stellar numbers in Q2, over the past week Wall Street analysts have lowered their 2018 Q2 EPS estimates by -$0.30/share to $38.80. Nonetheless, at the current pace, Q2 earnings would be record earnings and up +27.2% Y/Y! Also, the street significantly increased their 2018 EPS estimates by -$0.27/share to $157.97 but increased their 2019 EPS estimates by +$0.56/share to $176.39. This implies EPS growth of +26.9% Y/Y and +11.7% Y/Y in 2018 and 2019, respectively. Although our outlook is still below those lofty forecasts, we still see strong EPS growth for 2018 and 2019. We remain concerned about slowing global growth and margin pressures given higher employee and input costs, but the tax cut will overwhelm these concerns in the near term. As such, we raised our yearend S&P target slightly last weeky (to 3050 from 3000) and initiated a long bias.
U.S. GDP: Our GDP model sees 3%+ Real GDP growth through Q1 2019, but as higher oil and interest rates flow through the system, our model sees slower growth thereafter. Note that our model doesn’t factor in the stimulus from the recent tax cut, so the reversal in 2019 could be more pronounced than our model appreciates (it is presumed that 2018 will be better than our model due to the tax cut, whereas the delta for 2019 would be worse than our model predicts).
U.S. Inflation: U.S. inflation remains in an upward trend, and we continue to believe that wage inflation should continue to rise as labor slack (particularly in prime working age groups) continues to decline.
U.S. Federal Reserve: We believe two more rate hikes will happen in 2018 and the market assumes that those hikes will come in September and December (the market seems to think that rate hikes can only happen at FOMC meetings that have an attached press conference).
U.S. Treasuries: With inflationary pressures slowly building, and Real GDP trending well above +3.0% in Q2, we believe 10-year U.S. Treasury Yields will continue to trend higher and we would expect to see yields approach 3.50% by year end 2018.
U.S. Equities and Earnings: S&P 500 operating earnings are rising materially, but the question remains, will the market put a 20 P/E multiple on forward earnings? We think a 20 forward multiple is aggressive, but 18.5 may not be. Our SPX target is for an 18.5x P/E on 2019 forward earnings of $165, bringing our new 2018 SPX target to 3,050). We prefer financials given expectations for economic growth and an improving (steepening) yield curve. We also have a positive bias on the Technology and Health Care sectors.
Value Stocks Come Roaring Back from the Dead
By Dani Burger
August 6, 2018, 11:04 AM EDT Updated on August 7, 2018, 4:14 AM EDT
* Cheaply priced shares outperform momentum for second week
* Morgan Stanley says gains to continue on valuation gap
Cheap equities are in vogue at long last — lending a helping hand to stock markets hit by the recent trials and tribulations of tech companies.
If economic growth and strong earnings redress its undervaluation, the investing style may rebound in earnest — signaling there’s more juice left in the aging bull market.
But there’s a problem. Few can agree whether last week’s out performance in the U.S. and Europe was a head fake or a sign of things to come.
In the bullish corner are the likes of JPMorgan Chase & Co.’s Marko Kolanovic and Dennis DeBusschere at Evercore ISI. They argue value has the potential to pick up the slack, as cracks emerge in momentum equities thanks to earnings disappointments from companies such as Facebook Inc. and Netflix Inc.
“Despite ebbing trade tensions, the economic backdrop remained positive last week supporting the continued out performance of value,” DeBusschere, head of portfolio strategy, wrote in a Monday note. The sharp shift suggests a “meaningful rotation” out of momentum and into value is on the way, he said.
A market-neutral version of U.S. value outperformed momentum by 0.5 percentage points last week, the most in four months, data compiled by Bloomberg show. Meanwhile, momentum in Europe has declined 1 percent compared to a 0.1 percent value gain over the past week.
Still, one week of gains a trend does not make, particularly when you consider financials have the largest weighting in U.S. value. The recent bounce coincided with a steepening of the Treasury yield curve, which tends to boost net interest margins for banks. But that’s a situation few see enduring.
“We see a stronger macro case for the yield curve to continue its flattening trend which is likely to be a headwind for further value out performance if this relationship holds,” Mayank Seksaria, chief macro strategist at Macro Risk Advisors, wrote in a note.
On Monday the shift looked poised to slow, as U.S. momentum erased some of its losses while value was little changed. Morgan Stanley, for its part, sees room for cheap shares to power ahead, even as it warns the risks for a broad S&P correction have risen.
Over the past 15 years, the price-to-earnings gap between value and growth stocks has only been higher four percent of the time, according to data compiled by the bank.
Depressed valuations boost the appeal of value — and the high price of growth leaves the group acutely vulnerable. Since the latter prices-in strong future earnings, signs the business cycle might be turning is decidedly problematic for the allocation strategy.
“Rising valuation dispersion suggests a better backdrop for value investing,” strategists headed by Matthew Garman wrote in a note.