#$ive

By David Nelson, CFA

Denial, Anger, Bargaining, Depression & Acceptance - The 5 stages of grief first introduced by Swiss psychiatrist Elisabeth Kugler-Ross in her 1969 book, On Death and Dying are normally associated with a terminal disease. But in the context of finance they are often used to describe investor emotions in the throes of a bear market. Well known author and market strategist Barry Ritholz used it in his January, 2008 article for Seeking Alpha. His timing was perfect as we were still in the early stages of what would soon be called the Financial Crisis of 2008.  I’m sure market bears today feel it’s time to run this title up the flag pole once again. Market valuations are stretched, economic data hasn’t been supportive and 1st quarter earnings from investor favorites like Netflix (NFLX) and Alphabet (GOOGL)* have left investors cold. This week Barron’s cover story highlights their Big Money Poll pointing out only 38% of money managers are bullish on the outlook for stocks. While only 16% said they were bearish, nearly half the respondents said they were neutral on equities. (IMHO neutral is a term often associated with "I have no idea") With the market just a stone’s throw from all-time highs, I’m sure many would agree bulls are living in denial and the market is just one headline away from a crash. Let me turn the 5 stages of grief concept on its head and suggest it isn’t always associated with a coming bear market. The rally off the February lows has been described by the media as one of the most hated in recent memory. Usually, that means investors are leaning in the wrong direction or de-risked their portfolios at or near the bottom. For the last several weeks, the pain trade has clearly been up. When one sector or style loses steam another is close behind ready to take the lead. At the start of the year Utilities (XLU)*, the ultimate defensive sector was trouncing the rest of the field. In recent days it has slipped to #2 as last year’s loser, Energy (XLE) pushes into 1st place. 

The battle between growth and value has been with us since the dawn of markets. For the last 5 years the iShares S&P 500 Growth ETF (IVW) outperformed the iShares S&P 500 Value ETF (IVE) by a wide margin.

2016 has been all about value with growth and momentum taking a back seat. The ultimate momentum trade, FANG stocks - Facebook (FB), Amazon (AMZN), Netflix (NFLX) & Google (GOOGL) have given way to long-time laggards like Freeport (FCX), Hess (HES).

Let’s apply the 5 stages of investor grief to the recent rally: Denial - The rally is a dead cat bounce. New lows are just around the corner

Anger - It must be the Fed. Conspiracy theories run rampant

Bargaining - You’ve missed the rally and hope for any pullback to jump on board

Depression - You didn’t get the pullback you hoped for or failed to pull the trigger when it did.

By David Nelson, CFA

The S&P 500 is up modestly year to date but the action beneath the surface has investors feeling like heroes or zeros depending on their latest stock pick. This bifurcation is easily seen when comparing S&P 500 Value stocks (IVE) with its growth counterpart (IVW). Investors continue to crowd into a dwindling inventory of stocks still able to organically grow the top and bottom line while others rely on financial engineering gimmicks to prop up earnings.

Case in point

Amazon vs. IBM – Amazon (AMZN)* continues to invest hand over fist to grow its top and bottom line while (IBM) spends over $13 Billion annually buying back stock to prop up earnings. One has a multiple in the stratosphere while the other has a PE of less than 10. IBM says it’s moving to the cloud while Amazon is the cloud. I think it’s pretty clear investors don’t care how cheap your stock is if you aren’t growing.

2014 data shows about 100 companies in the S&P 500 spent more than 90% of their Free Cash Flow buying back shares. Of course all of this comes at the expense of R&D and CAPEX. If you don’t invest in the future eventually you become irrelevant.

The Fed has been complicit in the current wave of financial engineering. A prolonged Zero Rate Interest Policy (ZIRP) has had unintended consequences. Cheap debt has been an irresistible tonic for CEO’s anxious to meet stock compensation goals. Leverage lets you buy back even more stock and of course works right up until it doesn’t. I think the spread between growth and value is saying the jig up and it’s time for these companies to start investing for the future before it’s too late.

Wall Street has been singing the praises of stock buybacks for as long as I’ve been in the business but the winds seem to be shifting. Earlier this year, Merrill Lynch Quant Strategist Savitha Subramanian pointed out; “The efficacy of buybacks has been waning, whereas the few companies spending on growth have been generally rewarded.”

In April, BlackRock CEO Larry Fink sent a letter to CEO’s talking about the dangers of a short term approach solely focused on buybacks and dividends.

Once again, the S&P 500 is right up against resistance and nothing less than a breakout to new highs on big volume will convince traders the coast is clear. However, even if we get the breakout bulls are hoping for the only way to sustain it is for more companies to participate. And the only way that’s going to happen is more CEO’s managing with a horizon that goes out further than 12 weeks.

By David Nelson, CFA

A funny thing happened on the way to the bear market this month. Despite the best efforts of short sellers, strategists and talking heads everywhere, markets worldwide have staged a stunning comeback with most up mid-single digits month to date.

World Equity Performance October

The September Employment report was the liftoff for a short covering rally as the month’s biggest gainers have been low quality challenged companies many of which today are still down significantly for the year.

A short covering rally does not a bull market make but it’s a start. The NYSE Bullish Percent Index which had remained negative since May reversed back in September to the upside only to flip negative a couple of weeks later. As a reminder this longer term indicator measures the percent of technical point and figure charting buy signals on the New York Stock Exchange. A 6% change in direction reverses course. Sounds like a small number but it moves like a battleship.

Last week the indicator flipped positive once again setting up what is considered Bull Confirmed status. No it doesn’t mean that a bull market from here is a lock but it’s another data point on the side of the bulls.

Oil & the Dollar

Oil strength and dollar weakness helped buoy stocks last week for two reasons. First, if oil can even stabilize at these levels concerns for many companies in the oil patch whose debt will roll over in the next few months might subside.

The inability of the dollar to break out to new highs helps U.S. multinationals who have been complaining about the negative translation and its effect on earnings for most of the year.

Earnings

The acid test for the rest of 2015 will likely be Q3 earnings reports that start in earnest this week. More important than the actual numbers will be management commentary and guidance especially looking into 2016.

Are the effects of a strong dollar subsiding?

Is China getting worse?

Are managements comfortable about adding to cap ex?

What does organic growth look like for next quarter and beyond?

These are just a few of the questions analysts and investors will be zeroing in on over the next few weeks.

Does the commodity stock rally have legs?

The chart above gives me pause. The CRB RIND index measures industrial commodities and at least to date shows little sign of turning. If the recent turn in oversold commodity stocks is for real then this index will have to turn as well.

Growth Outperformed Value Year to Date

IVW iShares S&P 500 Growth vs IVE iShares S&P 500 Value

Is the tide going out for growth?

Since the start of the correction as economic conditions weakened growth outperformed value. This isn’t surprising in that growth often gets bid higher as it becomes scarce. The recent bottom marked a distinct change in the market’s character with value taking the lead as investors seemed unwilling to push their favorite growth stocks higher. If this trend has legs then portfolio managers will need to adjust.

"The best battle plan goes out the window once the bullets start flying"

Veterans know exactly what that phrase means.

The battle between growth and value has been raging since the dawn of investing. Growth investors are willing to pay higher valuations for above average growth while value investors look for low multiples like Price/Book and Price/Earnings. Each category has many subsets. In the growth camp are Momentum and GARP (Growth at the Right Price) while value caters to investors like Warren Buffet more focused on buying a dollar's worth of assets for 50 cents. In the end both can prove profitable but like most things in life, timing is everything.

The most recent battle can be seen comparing iShares S&P 500 Growth ETF (IVW) vs iShares S&P 500 Value ETF (IVE). As you can see in the 1 month chart above value investors are attempting to retake a lead they’ve relinquished for most of the last 5 years.

Clearly during that time investors have been willing to pay ever increasing multiples for companies that could consistently grow revenue and earnings. Healthcare has been the prime beneficiary with the biotech index now up 386% in that time frame.

In March of last year value stocks made an attempt to retake the crown lost since the dawn of the financial crisis. At the time, I sat down with Yahoo Finance Anchor Aaron Task to discuss growth’s waning momentum. My thesis was short lived as growth soon pushed ahead taking the baton from value and until recently never looked back.

What’s holding back growth?

Estimate Revisions - It’s no secret that estimates have been coming down most of the year and recent data has proved problematic for momentum players. The table from Thomson/Reuters speaks to a problem that seems to be getting worse. In the last week alone there were 86% more downward revisions than those revised higher. At present it looks like Q1 and Q2 could show negative year over year growth and most year-end projections are back-end loaded. If growth stocks are going to regain their mojo, this dynamic has to change.

There’s more to growth stocks than just price momentum. Growth investors look to companies with a steady stream of estimate revisions to the upside as well as the ability to beat those raised expectations. The current environment is not what the Doctor ordered. While there will be plenty of earnings beats in the quarter reporting, 2015 should probably have an asterisk.

* Estimates have been cut dramatically since the start of the year so the bar may be low enough for many companies to step over.

The Dark Side of M&A

Many seem to think M&A could drive the next leg of the bull market. When two vibrant companies growing organically join forces the sky’s the limit. However, recent M&A proposals like Royal Dutch’s (RD) take-out of BG show the real driver behind their purchase may be the $2.5 Billion in annual synergies. The cost savings could drive earnings growth in a sector that is clearly challenged. I expect more deals between companies looking to cut their way to profitability.

Timing is Everything

I said earlier that timing is everything and as in life so it is for investors. I can’t remember where I first came across the Stock Clock but it shows the importance of reasonable timing.

Value Investor - We would all like to be deep value investors, picking up stocks at a cycle low but it’s probably the toughest of all strategies. The company is generally dealing with severe issues that have torpedoed earnings and their stock price. As you can see in the graphic the good value investor usually sells early to the...

GARP (Growth at the Right Price) Investor - Searching for companies that already are past their inflection point they look for companies that are growing top and bottom line but still with reasonable valuations. If the investment works out this investor usually sells out to the...

Momentum Investor - MOMO investors, as they are often referred to, are comfortable buying late in the cycle as long as the trend and price momentum remain intact. Good momentum investors ultimately sell to the...

Bad Momentum Investor - This unfortunate group has identified the security to late and is likely in at the top or very close to it. Eventually after succumbing to heavy losses they capitulate selling to the...

Bad Value Investor - Bad value investors are looking for all the same attributes as the good value investor but unfortunately has entered the security too early. Unwilling to suffer more pain they often sell to the good value investor and the cycle starts all over.

The important take away is that there are many styles of investing that can succeed but in the end, timing is everything.

Look Ahead

Over the weekend People’s Bank of China announced a full 1 percentage point cut in the reserve requirement the largest they’ve made since 2008. Given recent data coming out of the country it’s clear they’re concerned about growth.