8 May 2023 “Objects in the mirror are not as bad as you thought they were” After several sub-par quarters and a period of aggressive estimate cuts, Q1 earnings reports have broadly beaten the reduced earnings forecasts. This has triggered not just higher stock prices but a broad and rapid upturn in the pattern of […]
We often hear the narrative that rising long-term bond yields are harmful to valuations of “long duration” Growth stocks, especially the Technology sector that dominates the Growth style. This has been evident in day-to-day swings in the market recently.
While we understand the concept embedded in discounted cash flow models that higher discount rates depress current equity values more when capitalizing earnings that occur further in the future, we have been skeptical that the discount rate effect in most cases is sufficiently large to dominate changes in growth expectations or investor risk tolerances, at least for the Tech sector. In other words, our view has been that an investor’s bigger concerns when evaluating higher-Growth Technology stocks are the future earnings growth rate and the risk involved, not whether Treasury bonds yield 1.5% versus 2%. Changes in growth expectations and investor risk perceptions will typically have much larger effects on stock prices than moderate changes in Treasury yields, especially when interest rates (and real rates in particular) are at such a historically low level.
As Q3 earnings season gets underway, stocks in the Financials sector are in focus as they are typically among the first to report earnings. While history indicates companies are on average likely to beat Q3 estimates, our indicators, which have been supportive for Financials all year, are now starting to weaken and suggest it might be time to take profits in the sector and reallocate to other areas.
In recent months, two of our strongest US sector allocation views have been to overweight Financials and underweight Health Care. A key feature of our sector work is that we often look at sector indicators on a “pairs” basis, i.e., the relative return, earnings momentum, and valuation of one sector versus another (as opposed to comparing sectors only to an overall benchmark like the S&P 500). This allows us to see the underlying relative performance drivers more clearly.
Among the biggest losers from COVID-19 and the resulting work-from-home trends that followed was the commercial real estate industry. Office buildings and retail stores that had been mostly full in 2019 were suddenly empty, and the companies that had been renting the space were often unable or unwilling to continue paying. And while stimulus support has helped much of the economy, the impact on commercial real estate has been more limited.
One of the most notable market trends in recent weeks has been the corrective action in the formerly high-flying US large-cap Growth stocks. The dominant Tech-oriented companies that have been responsible for much of the gains in US large-cap indices for several months finally saw some significant selling pressure in the first two weeks of September.
The first chart below shows absolute and relative returns for the S&P 500 Pure Growth and Pure Value indices (i.e., the style indices restricted to stocks that fall entirely into their indicated style, leaving out those with weight in both indices).
Much of the attention in equity markets has been focused on the Technology sector, many of whose constituents are reporting Q2 earnings now. The Technology sector has outperformed dramatically both in the US and globally in recent years as well as for the year-to-date. This has raised questions about whether the sector is “overowned” and overvalued, particularly given its unusually high weighting in the S&P 500 index now.