The rotation begins as the waiting game continues
Why we think the rotation out of tech could have legs over the next 6 months.
Just a short 10 days ago, having reached our longstanding 3,500 target on the S&P 500, we published a piece setting a new, higher 3-year mark of 5,000 on the S&P, while at the same time warning a September consolidation was likely, driven by a rotation out of growth/technology stocks. Timing is everything. The next day, the tech-heavy Nasdaq began a weeklong decline (so far) of over 10%. Before I take up day trading for a living, let me state for the record that I had no idea whatsoever that the correction I alluded to loomed less than 24 hours away. But 40 years of doing this has left me with sufficient scar tissue to know that nothing grows to the sky, however strong the fundamentals. And short-term risks rise all the more when short-term momentum trading becomes the rage and do-it-yourself investors begin imagining they can get rich quick on the latest internet trading platform.
In my next few pieces, I want to focus a little more heavily on some of the shorter-term issues we see driving the markets, both in terms of risks to, and reinforcement of, our longer-term optimistic outlook. Today’s piece will focus on the first of these, which is the transition underway in the U.S. and global economy from recovery to expansion.
A brief history of how we got here
The recession we entered this February and likely exited this June was one of the shortest and deepest on record. It lasted just four months and in that time, GDP declined 10.2% (roughly 20% annualized) and the unemployment rate exploded from 3.5% to a high of 14.7%. Since then, a sharp recovery has been underway, with GDP expected to expand at an annualized 23.2% in Q3 and probably another 8.9% annualized in Q4 (Federated-Hermes’ updated forecast). But this has been one of the most unusual recessions and recoveries in the history of the country and indeed the world, not just for its speed and depth. Never before has the entire U.S. economy been locked down; never has the federal government spent $2.79 trillion on a giant bridge loan to keep that economy afloat; never has the Fed ballooned its balance sheet anywhere in the remote vicinity of its present $7 trillion. And never has the U.S. private economy transformed itself in such a short period of time to what it became under the Covid-lockdown, a “virtual” world in which an enormous swath of remaining economic activity was conducted virtually.
A new framework for investing
At Federated-Hermes, one reason for our success this year in the markets has been our recognition early on that the combination of forces outlined above made virtually all of our existing templates for thinking about the economy moot. As readers of this space know, we developed a fresh framework for thinking about the world that has helped us and our clients navigate these perilous waters. Covid progression became the key driver; fear of Covid the key risk. Federal “bailouts” became “bridge loans.” “Unemployment” became partly “temporary furloughs.” And “creative destruction” became “accelerated creative destruction,” with a violent search for winners, losers and survivors far more important for investing than the outlook for broad market averages. You get it.
What has the growth-value rotation have to do with it?
Sometime in the first half of 2021, the U.S. economy likely will re-achieve its previous level of GDP output, ending what economists officially call “recovery” and entering a more ordinary third phase, “expansion.” While the speed and length of that expansion could well depend to an extent on which political party controls the executive and legislative branches of the federal government post-November (or post-December—more on this in an upcoming piece), our entrance into this expansion phase now seems to be more a question of which month in 2021, rather than which year. For stock market investors, the increasing visibility around this transition is occurring at just the point where the winners in phases one and two—the technology/new economy-driven “growth stocks”—are completing a cycle of outperformance of their older economy “value” peers that is beyond historic in nature; 40% year-to-date through August, according to the Russell Growth and Value indexes! Much of this outperformance is deserved; these are companies that were winning the game prior to Covid, and because their business models were most adaptable to a Covid world, saw their lead within the economy expand exponentially in the crisis and early recovery. As we’ve noted repeatedly, their fundamentals already were quite strong entering 2020 and on our numbers, getting markedly better, not worse. Their valuations as we measure them expanded accordingly, from cheap in 2019 to fair by June of this year. But as the momentum traders piled on, those valuations have now drifted into expensive territory even as leading old economy companies see their valuations plumbing new depths.
As the recovery moves to expansion, however, the degree of the valuation gap enjoyed by the “growth stocks” appears excessive, at the margin. Many surviving companies in the value bucket—industrials, leisure, transports, housing, financials, energy, international and emerging markets (EM)—stand to benefit disproportionately from the likely resumption next year of more “normal” economic activity. And while the growth stocks are likely to continue to see improving prospects in the years ahead, in 2021 the year-over-year comparisons against the history-making shift to the internet that occurred in 2020 will become a difficult hurdle to work through. Increasingly, our stock-picking teams at Federated Hermes are confirming this view, with portfolios gradually shifting to now cheap old economy survivors and taking profits in some of our highest-flying growth stocks that have carried us so well to this point. And as noted in my last memo, our PRISM® asset-allocation committee has likewise scaled back our pro-growth stance, in favor of value stocks along with their foreign cousins, the international and EM companies.
And to answer your next question…
Before you ask it: we are therefore not buyers of this Nasdaq pullback. Unlike previous “false dawns” of the value trade in 2019 and 2020, this one seems driven more by a coming economic reality, which the market as usual is trying to discount six to 12 months in advance. If we’re right, as more normal economic activity resumes, value names may be about to enter their day in the sun, while the overall market averages grind modestly higher as the growth names consolidate. We don’t think the game is over yet for the new economy companies, and their resurgence later next year seems likely as investors begin to look through to 2022 and 2023, along with “S&P 5,000.” Given this, we’ve only cut back to neutral here, and are likely to hold on to our core positions through the transition storm as it continues to rage. But our equity overweights are now squarely in value and international. So sharpen your pencils. There’s work to be done on a new set of stocks.