It is not coincidental, in our view, that the stock market peaked on May 21st, one day before Ben Bernanke testified in front of Congress’s Joint Economic Committee. Although prior to that day the Fed had gone to great lengths to delineate the scenario under which it would begin restraining its accommodative monetary policy based on hard facts about the U.S. economy, the Chairman’s testimony that day made clear that the beginning of such unwinding would come sooner rather than later. The next day markets stalled. Wednesday’s press conference, following the FOMC’s latest two day gathering, only confirmed and clarified what the market had been discounting for a month: that the bottom of the punch bowl was beginning to show. And even though Bernanke painted a rather rosy picture for the U.S. economy, raising the Fed’s expectations for next year’s GDP growth of 3 to 3.5%, accompanied by unemployment falling below 7%, moderate inflation and a housing market decidedly on the mend, markets sold off around the world, with U.S. stocks losing 1.4% by the end of the trading session. This was followed by Thursday’s 2.5% decline, which also saw the 10-Yr. Treasury yield climb to 2.419%, its highest level since March 2012. With firmly grounded expectations that QE will begin to shrink later this year and perhaps be altogether ended by next summer, it is clear to us that financial markets are entering a new phase after five years of emergency measures and extremely loose money.
What does this mean to stock investors, particularly those of you who follow B400? In general terms it means a gradual return to investors relying on the market’s price discovery mechanism for the asset that matters most to financial markets: money. This explains, in our view, the breadth of this week’s sell-off, which seems to have come mostly from hedge funds and the like, or those most willing and able to channel free central bank money into risk assets, particularly stocks. Evidence of this appeared in a Stifel Nicolaus & Co. report, cited by The Wall Street Journal, highlighting that 41% of dollar volume in U.S. equity trading on Thursday came from ETFs, compared to this year’s average of 24%. What seems, then, to many, part of what’s been called “the great rotation” of assets out of fixed income and into stocks and other risk assets, we would rather call “the end of the Great Distortion.” If further evidence of this shift is needed look no further than the source of the loudest complaints this week about the Fed’s new stance: bond fund managers. Understandable, given that the 30-year bond bull market seems to be in its closing chapter.
In our view, one of the most important points in the Fed’s recent remarks, which has been surprisingly overlooked, has been its stance about and expectations for inflation to remain largely subdued. Annual CPI inflation is running at a 1.4% annual rate, well below the Fed’s 2% target, a sign of a still-deflationary environment, symptomatic in our view of a world that is still deleveraging. Yes, the U.S. is growing slowly but the rest of the world seems to be going from stall speed (emerging markets) to downright crashing into a wall (Europe). Which brings us (finally) to B400. With inflation running below central bank expectations and sluggish growth in the developing world—the source of growth following the 2008 great recession in developed economies—we think one particular type of asset will be at a premium in the next couple of years: growth assets. This is precisely what B400 owns, as explained earlier this week by John Prestbo in one of his regular B400 Diaries (see: B400 Is a Growth Index, and the Price Is Reasonable). With money no longer as cheap as it’s been the last five years, investors will need to be more selective about where to put it to work. And as long-term investor money continues to decouple from fast, speculative money, so fond of the carry trade, quality should once again shine.
This, of course, is also where B400 excels. A quick review of some of the key data points in our B400 Snapshot page underscores this. B400 companies are trading, on average, at 18 times forward EPS estimates compared to a forward PE of 15.2 for the Dow Jones US Total Stock Market Index, which shows investors are clearly willing to pay a premium for growth; evidence of which is an average 3-Yr. EPS growth rate of 33.5% for B400 companies and average 3-Yr. revenue growth of 64.6% for the same group. Such growth traits are also visible in the B400’s average MarketGrader grade of 64.4 compared to 42.6 for the aforementioned total stock market index or 58.3 for the blue chips in the Dow Jones Industrial Average.
From a sector allocation perspective, B400 also seems pretty well positioned for a market that favors growth, with 20% in both Consumer Discretionary and Industrials, followed by 16.5% in Technology. Its smallest sector is Materials, currently representing only 2.8% of the index’s components, which seems almost fortuitous given not only the current slump for commodities but what is sure to be further price declines in the face of a strengthening dollar. Not to mention, of course, China’s long awaited economic rebalance (toward consumption and away from exports and capital investments) and an apparent supply overhang from the excessive build up of the last half decade.
Finally, B400’s average dividend yield of 1.1% compared to 2.1% for the broader market is another example of investors willing to pay more for tomorrow’s earnings than they are for today’s profits (dividends). B400 was not designed for yield; it was designed to help investors capture the capital appreciation of the market’s most promising stocks. Such capital appreciation usually comes from growth, particularly in times of normal interest rates.
