Stars aligning for Team Value
Its offense (dividends) and defense (lower multiples) play well in current environment.
Investors are getting increasingly skittish—the Investors Intelligence bull-bear ratio is nearing levels seen at market lows. Many retail investors, who are buying equity funds at a pace similar to a strong 2021, are taking cover in dividend and value stocks—sectors such as Energy, Financials, Industrials and Consumer Staples that tend to have lower P/Es and an ability to adjust to, and in many cases benefit from, higher prices and rates. They have outperformed the broader market year-to-date and still appear significantly undervalued, energy in particular. With collective earnings of $100 billion over the past year, energy earnings are far below their 2008 peak of $163 billion and should set new highs if oil prices and energy demand keep rising. Even if Russia-Ukraine tensions dissipate and Iran’s oil exports ramp up, Piper Sandler sees structural and cyclical demand supporting further market buoyancy and refining margin strength. These include a downshift in China’s oil product exports, ultra-high natural gas prices that are putting European and Asian plants at a disadvantage and global reopening (the International Energy Agency just revised up 2020 and 2021 oil demand by a whopping 1 million barrels/day). What’s good for energy is good for dividends—the S&P Energy sector sports a yield of 3.4%, and since 2018, the average dollar amount of dividends among energy companies has grown by more than 50%. Since the U.S. now produces about the same amount of energy as it consumes, what’s good for energy tends to be good for the economy, as well, with higher prices elevating capital expenditures and lifting rather than lowering real incomes.
With Energy, Financials and Industrials dominating the S&P 600 Index, what’s good for these Value sectors also tends to be good for small caps. Bank of America projects small-cap earnings will grow 14.5% over the next 12 months, well above its 8.9% forecast for large caps. Yet valuation indicators indicate small caps are the cheapest they’ve been in over two decades relative to large caps. Historically, small caps trade at a premium to large caps but the S&P 600 currently carries a 14 forward P/E versus 20 for the S&P 500. Small caps do tend to be more sensitive to changes in rates and economic conditions. But however fast the Fed tightens—this week’s minutes were vague, other than suggesting policymakers may step up the timetable for hikes (more below)—the increases would be coming off zero and in an economy far from recession. Despite surging Covid cases, employment, retail sales, existing home sales and industrial production all beat in January (more below). Now, caseloads are plunging and restrictions are easing all over. Whatever the Fed does in a month, history indicates equities tended to firm up three to four months after the first hike and make fresh all-time highs within six to 12 months, largely because the start of policy tightening almost always represents confirmation that the cycle has legs. And what if risk markets are over-adjusting to monetary policy shifts (seven hikes are now priced in over the next 12 months), pushing short-term rates too far versus what central banks ultimately do? It’s happened before (more below).
Year-to-date bond fund sales have reversed after last year’s record $1 trillion of inflows. Seems small investors, suffering from low savings rates for decades, are aghast at seeing negative signs on their bond returns. This outcome likely will continue until inflation starts to moderate. (The word “transitory” was nowhere to be found in the latest Fed minutes.) The 10-year Treasury yield’s breach of 2% marks only the sixth test in 40 years of its long-term trend. The others occurred with the ’87 crash, the ’00 market top, the ’06/07 mortgage crisis and the ’18 20% pullback. Uh-oh. The bond market has erected a Wall of Worry, with the futures-based yield curve flattening more than 140 basis points since last year. But on the strength of housing market shortages and enormous consumer and corporate liquidity—there’s an estimated $2.2 trillion in unencumbered household savings and corporate cash flow is at a record high—Empirical Research believes the economy can tolerate higher rates off historic lows. The V-shaped economic recovery attracted investors to cyclicals—Team Value’s offense. And now, the stars are aligning for Team Value’s defense as negative bond returns, limited prospects for multiple expansion and volatility support the case. On average, dividends have accounted for almost 60% of the total S&P return each decade since 1930. Share repurchases have been replacing dividends as a tool to return money to shareholders. But as Strategas Research notes, companies are far more likely to buy back shares when their prices are rising than when they’re falling. In this respect, share repos are like dating; but dividends … they can be more like marriage!
- The consumer is resilient Retail sales surged 3.8% in January, more than doubling consensus, and stronger gas spending did not come at the expense of other discretionary spending. Sales improved across categories except food services and drinking places, where omicron kept customers away. With cases now fading, 20 of 40 reporting states say restaurant seatings have risen above pre-pandemic levels, year-over year credit card spending jumped 15% the week ending Feb. 12 and Evercore ISI’s proprietary retailers survey soared this week.
- Americans want to live in a home Existing home sales surprised, jumping 6.7% month-over-month to an annual rate of 6.5 million in January, the highest level in a year. Despite the headwind of rising mortgage rates, housing is expected to accelerate this year amid strong demand, unusually low inventories and, according to the National Association of Realtors, a still high level of affordability.
- Machines can’t catch the virus January’s 1.4% increase in industrial production more than tripled consensus, mainly on utilities that saw strong heating demand amid a cold snap over much of the country. Manufacturing rose more modestly, with improvements in machinery and electrical equipment offsetting declines in supply-challenged motor vehicles and petroleum products. For February, New York’s Empire gauge moved back into expansion territory while Philly’s softened but remained robust.
- Maybe this is the peak for inflation? Pipeline pressures firmed in January after cooling in December, with headline PPI up 1% month over month, core up 0.8% and “core core” (excludes trade services) up 0.9%. All were notably above consensus, as was last week’s surprise pop in CPI. However, expectations have yet to harden. The monthly New York Fed survey of consumers put inflation three years out at 3.48%, its lowest since April. The year-ahead rate also moderated but was still high at a 3-month low of 5.8%.
- Maybe not … Rents are surging and food inflation approached its fastest pace of the last quarter century. Virtually every inflation gauge shows price pressures broadening—the Cleveland Fed median CPI and the Atlanta Fed sticky price index are each rising at their fastest rates in three decades. Globally, February’s World Food Price Index was the third highest in the series, which dates to 1990.
- January’s soft patch Housing starts slipped but permits rose, a sign January’s bad weather and ongoing supply shortages likely inhibited groundbreaking. Builder confidence also ticked down but remained elevated. Winter often sees fluctuations in construction activity. Elsewhere, Conference Board leading indicators slipped for the first time since last spring on omicron’s surge, elevated inflation and supply-chain disruptions.
What happens if Russia invades? Deutsche Bank looked at past geopolitical upheavals and found their impacts on the S&P tend to be short-lived, with a median sell-off of -5.7%. Markets tend to take about three weeks to hit bottom and another three weeks to recover prior levels. On average, the market was up 6.5% and 13% from the bottom, respectively, three and 12 months after the disruptions.
It’s hard to predict what the Fed will do If past is prelude, the Fed will do something dramatically different than the nine hikes this year and next that the market is pricing in. Since 1994, market predictions made in February of the fed funds rate most often have overpredicted the amount of future tightening by nearly half a percentage point for the same year-end and more than a point for the following year-end. Fed minutes reflected hesitancy toward an inaugural 50 basis-point hike but openness to more and faster increases.
Supply chains slowly normalizing UBS’ proprietary supply chain stress indicator, which condenses over 20 different measures, has improved 37% since its October peak. Increased air freight, a shift from goods to services expenditures, slowing global manufacturing orders, dwindling port congestion (the shipping queue outside Los Angeles has shrunk by 40 ships since early January) and a ramp-up in global semiconductor production have all played roles.