The question on everyone’s mind right now is, “What is going on with the market?” The answer to that question depends on which part of the market you’re looking at. Sightline’s Warren Gerow discusses market rotation, where we are in the cycle and how government policies intervene (or sometimes interfere) with the functioning of our economy. As earnings are released, it is important to keep in mind the historical context Gerow discusses below.
Value vs. Growth
One of the characteristics of value investing is a low price-to-book and margin of safety to the intrinsic value of a stock. Intrinsic value is defined as the calculation of an asset’s worth based on a financial model. What a value investor attempts to do is buy $1 worth of assets for less than $1. A margin of safety of 50% would mean buying a $1 asset for $.50. Growth investors, on the other hand, care about the future growth prospects of a stock without putting too much emphasis on price for that future growth. Another metric often used to determine the richness of a stock or market is the price-earnings ratio. Both measures rely on fundamentals of the company. Sectors often thought of as value sectors are retail, banks, energy, utilities, and industrials. Technology and healthcare are considered cyclical and are growth stocks. The problem with this view is everything has a cycle, even value and growth styles of investing. Today is a case in point. Value is underperforming growth and has for well over ten years. It is suggested in some circles that value investing is dead, at least for the time being.
Recently, the markets have separated from the economy. What we have today is cheap relative historic prices and asset values in certain sectors like energy and precious metals, for example. Many value investors buy the most hated stocks in out-of-favor sectors. After a historic correction in March and April, the market is back near the levels of the beginning of the year with the technology-laden NASDAQ index reaching new highs. A handful of technology stocks and stay-home service stocks (growth stocks) account for the bulk rebound. We began the year with valuations stretched. With a collapse in earnings for many sectors and little expectations of recovery until sometime next year, the general market is more overvalued now than it was at the beginning of the year.
Expectations Matter, Not Just Cheap Assets
Next, the stocks need to have some sort of positive earnings expectations for the stock to rise. In many cases, a catalyst is needed for the investor to recognize asset value and the new earnings growth potential. Take energy, for example. Let’s say energy stocks are trading at 10 times earnings. So, energy stocks represent good value. But what if suddenly, the government mandates the use of electric cars. What happens to energy stocks? They collapse and become even cheaper. That is “value trap” because the future use of energy is very uncertain, and the level of demand is expected to be greatly reduced. Fiscal, monetary, and regulatory policies influence economic expectations, which often has a direct bearing on asset prices.
Policy Response or a Natural Cycle?
Next, fiscal and monetary policies can distort the economy like we have seen today. The COVID response has benefited technology, for example. This is policy response, not part of a natural cycle. Interest rate policy has added another dimension of distortion. To stimulate the economic growth, Central Banks globally are keeping interest rates at historic lows. It isn’t working. Why? Because investor sentiment is not responding in a way that the economist thought. Once certain thresholds are reached, the response changes. When interest rates fall below 4% as studies suggest, consumers slow spending and increase savings. The “why” is another discussion.
Next, add investor sentiment. If we are excited about the future, then we invest with optimism. We gravitate toward stocks we think will participate as general economic conditions improve or have a chance of improving. Investor sentiment can create momentum and drive valuations beyond what is thought possible, for example Tesla. This seems to be happening currently with a handful of technology stocks responsible for most of the market recovery from the April lows.
Physics teaches us about waves and cycles. Everything has a cycle. Nature is based on cycles. Our four seasons are a perfect example of a cycle: spring, summer, fall and winter, for example. It works in perfect harmony. Capitalism is the same. Think of the old business cycle that is often referred to. Companies start, grow, mature and collapse, and then the next cycle begins – it is a perfect cycle. Often when government policies try to keep the party going longer than it should, it eventually fails. It is not natural.
Many years ago, we rotated from value to growth. The problem is, today there are many distortions, fiscal and monetary policy responses, to keep the party going longer than is natural. Investor sentiment has been the driving force influenced by several factors, not just optimism. Negative sentiment can drive the market higher as well. For example, low interest rates are forcing people to buy high-yield income stocks to replace bonds, which have little or no coupon.
Additionally, we must think not only about the economic forces but also social and political influences. Critical thinking is no longer taught. This does not bode well for economic growth and recovery in a free market. If there is one lesson history teaches us, it is to expect the unexpected. The unexpected has arrived. We are at an extremely critical time in our history and markets are going to be nervous for years to come. Value investing may take longer than we think to re-surface, but it will eventually.
Warren Gerow is an independent investment wealth consultant to Sightline Wealth Management.
Sightline Wealth Management LP (“Sightline”) is an investment dealer and is a member of the Investment Industry Regulatory Organization of Canada (IIROC) and the Canadian Investor Protection Fund (CIPF). Sightline provides management and investment advisory services to high-net-worth individuals and institutional investors primarily through fee-based accounts.
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