Tactical Views on the Year’s End and Beyond
With just a little more than a month remaining to year’s end, we’re reflecting on the market’s performance thus far as we strategize the final push and begin to think about how to plan for 2016.
Two themes stand out for us: reversion to the mean and owning the year’s winners. The application of these themes is a matter of timing; owning the winners in a narrowing market may work through year-end, while reversion to the mean will be a longer-term story.
It’s been a difficult year for U.S. investors, with the S&P 500 barely up year-to-date. However, as in the past, averages conceal a wide dispersion of results. The sectors of the S&P have varied widely in performance, from the chart-leading consumer discretionary sector, up almost 17 percent, to the heavily punished energy sector, down more than 22 percent as of this writing.
Data Source: Fidelity
However, drilling down, those sector performance numbers don’t capture the dispersion of the industries within them. Let us start by breaking down the consumer discretionary sector, which has been the index leader. It is an instructive exercise:
We can see where the winners and losers were in that sector, and while some results are surprising, others are not (based on some the longer-term themes we see being driven by major global social and technological shifts). One thing we can say very clearly is that it is not particularly meaningful to talk about the performance of “consumer discretionary.”
A similar, though not as extreme dispersion can be seen in the information technology sector:
Data Source: Fidelity
And finally, here are the industrials, which have shown a decline of about 1 percent year-to-date — also showing a wide dispersion between leaders and laggards:
Data Source: Fidelity
Market action this year has been volatile, characterized by abrupt sector and industry rotations which have been difficult for traders to navigate. This action has seen sectors, industries, and individual companies both punished and rewarded excessively. In brief, the markets have been in the grip of fear — and it has often seemed as though market participants experienced the fear first and sought a justification for it later. They have seized on any available data points that could be construed as support for a bearish position, from the Chinese stock-market crash to the more recent apparent global industrial slowdown.
The dispersion we observed above affords opportunities on several fronts.
In the nearer term, as we note below, we believe that through the year’s end, active investors would do best to hold the year’s winners. Losers are likely to be sold to harvest tax losses. As a wise man once said, “To everyone who has, more will be given… but from him who has not, even what little he seems to have will be taken away.”
We believe the trend into year’s end will be more rewards for the winners, and more punishment for the losers. We’ve shown the dispersion of some of the most significant and representative S&P sectors above, but we would recommend that investors make a similar examination of the rest of the S&P as well. Favored stocks in this environment include especially big cap tech stocks which have outperformed this year and have broken out decisively — including Microsoft (NASDAQ: MSFT), Facebook (NASDAQ: FB), Alphabet (NASDAQ: GOOG), and Amazon (NASDAQ: AMZN). (Note: GIM owns MSFT, FB, GOOG, and AMZN for some clients.)
Reversion to the mean
From a medium-term view, however, preparing our minds for 2016, we are cautious about U.S. and global stocks. One theme that may play out well will be reversion to the mean. We believe that many industries and companies that have underperformed have been punished excessively — either by a market sentiment that has gone to extremes in negative psychology about global trends, or by a market mechanism that has aggregated index components in such a way that sound companies have been pulled down by the ETF undertow.
As the renowned investor and stock-picker Sir John Templeton observed, “The four most dangerous words in finance are ‘this time is different.’” Some patterns do indeed recur reliably, and reversion to the mean is one of them. Battered companies, industries, sectors, and economies that have been punished harshly by market participants’ psychological overreactions eventually rebound, and after this year of fierce rotation, there are many places to look for them. The key is to observe them in the context of fundamentals as well as psychology to discern when that overreaction has driven them to their near-term low.
We are watching beaten-down countries, sectors, industries, and individual companies that we believe have fundamentals more favorable than overreacting market participants have given them credit for — and looking for the ones where those fundamentals may be set to experience a positive acceleration.
Much pessimism among market participants, for example, has focused on disappointing industrial production data. As we note below, we believe that those data are not as significant as services data that don’t receive anywhere near the media coverage and thus don’t influence market psychology as deeply. However, growth in services seems actually to lead rather than to lag industrial growth — leading us to believe that a bottom in industrial data may be nearing, and thus also, potentially, a bottom in the accompanying negative psychology.
Investment implications: A more-or-less flat year for the S&P 500 as a whole conceals wide dispersion in the performance of different sectors, industries, and individual companies. This year, nervous markets have handed out both excessive rewards and excessive punishments, and we see two strategies as we head into the year’s end. First, many market participants may seek to harvest tax losses, selling their losing positions; we believe the year’s losers could be punished, and the winners rewarded. Second, however, we see ample scope for classic reversions to the mean, as oversold countries, sectors, industries, and companies return to valuations that more accurately reflect their fundamentals — especially where those fundamentals are seeing positive acceleration.