Here are just a few points that illustrate why we believe this cycle will eventually turn in our favor:
U.S. profit margins (and earnings growth) have been coming down, as we expected. But margins are still high relative to history and are likely to continue lower if and as wage pressures continue to build as the labor market tightens. Higher interest rates (and therefore higher corporate borrowing costs) would also be a negative for margins. Current corporate profit margins have been negatively correlated with future earnings growth. That is, historically high profit margins are associated with low five-year forward earnings growth and vice versa. If topline revenue growth remains subpar and profit margins decline, earnings growth will remain under pressure.
Meanwhile, on the valuation side, we see little room for market-multiple expansion in the United States. U.S. and Foreign StockThe 12-month trailing price-to-earnings ratio for the S&P 500 is 24x, and the 12-month forward P/E ratio is 18x (using analysts’ consensus forward earnings estimates). These are both historically high levels. Our base case scenario assumes the P/E multiple contracts over time, bringing it in line with longer-term historical averages. Putting it all together, it means poor expected returns for U.S. stocks.
In contrast, developed international and emerging markets are almost a mirror image of the U.S market, with below-normal earnings and the potential for faster earnings growth from current levels. We also expect valuation multiples to expand somewhat from current levels as earnings improve. On this point, one additional supporting factor is that foreign markets have already suffered a steep decline, as if the markets expect a global recession even though it isn’t at all clear we are in such a recession or about to fall into one—although that’s one reasonable near-term scenario. In other words, at the low in February foreign stocks had discounted a lot of negative news, setting them up for a potential rebound if actual events turned out to be no worse (let alone better) than expected, which seems to be what we’ve seen over the past month.
Value (Low Multiple) Versus Expensive (High-Multiple) Stocks—In another unusually long Value Has Outperformancemarket cycle, this has been the longest run of underperformance for value stocks on record going back to 1930, at nearly 10 years (outlasting the six-and-a-half years of the Internet/tech stock bubble). The flipside has been that on the other end of the style spectrum, expensive growth and momentum stocks have had unusually strong returns.
The chart to the right also shows that over the long term a value investment approach has meaningfully outperformed a strategy of buying expensive (high-multiple) stocks. But there are cycles. Value investing has had several periods of significant underperformance. The inability of most investors to stick with a value approach during such cyclical reversals is likely what enables the “value premium” to persist over the long term. And the short-term performance-chasing tendencies of most investors pushes the pendulum still further.
So both of these cycles have been headwinds to investors like us who are valuation-driven and look at things on a longer-term “normalized” basis (i.e., based on reasonable estimates of earnings and valuations through an entire cycle as opposed to overweighting a single point in time that may reflect unsustainably high or low earnings). As such, we have been underweight (expensive) U.S. stocks and have found (cheaper) foreign stock markets more attractive in terms of their expected returns relative to risk. In addition, many, though not all, of our active fund managers have a long-term value approach as well and have lagged the broad market benchmarks at least in part due to the factors highlighted above.
Consequently, the reversal in the markets starting in February may mark a change from a cyclical headwind to a tailwind for our tactical positioning, as well as for many of our active equity managers. From the February 11 low, the MSCI ACWI ex USA Index is up 13.2% beating the S&P 500 by 21 basis points. Emerging-markets stocks have rebounded 17.7% (and are up 21.9% from their January low). The MSCI ACWI ex USA Value Index has jumped 14.5%, beating the MSCI ACWI ex USA Growth Index by more than two-and-a-half percentage points. European and emerging-markets stock indexes also have larger exposure to cyclical and traditional value sectors (such as financials, materials, and industrials) than the S&P 500. (Compounding both of these effects, our deep value, actively managed emerging-markets fund is up a whopping 30% from its January low, after suffering a huge drawdown over the previous year and half.) Our flexible and absolute-return-oriented fixed-income positions have also performed nicely since the market lows, gaining anywhere from 2% to 7%, while the core bond index returned less than 1%.
Will Recent Market Trends Sustain?
We have started to see references by several market strategists and investors to the potential for a so-called reflation cycle to kick in. James Paulsen, chief investment strategist at Wells Capital Management, recently laid out a scenario in which the recent market reversals may be the beginning of some new cyclical trends.
