Tanvi Kandlur: Are we set for a market rotation in US equities?

October saw the markets punish Apple and Amazon for lowering Q4 forecasts

US equities this year has been the best performing asset class resulting from both strong consumer and business sentiment and robust US earnings across most sectors, helped by the corporate tax cuts.

Year-to-date, funds with a significant growth tilt have continued to be the best performing funds and unsurprisingly those that invest in cheaper segments of the US market with greater value have been among the worst.

Top Performing FundsYTDOct 1st – Oct 12th
Baillie Gifford American B Acc22.1%-14.2%
Morg Stnly US Growth F USD18.6%-9.9%
Brown Advisory US Sustainable Growth C17.4%-7.9%
Seilern Stryx America HR USD16.7%-8.0%
T. Rowe Price US Large Cap Growth Equity Q GBP15.8%-6.9%
Bottom Performing FundsYTDOct 1st – Oct 12th
MFS Meridian US Equity Opportunities WH1 GBP-7.9%-5.8%
VT De Lisle America B GBP-5.2%-7.1%
Barclays GlobalAccess US Equity M Acc GBP-5.0%-5.4%
MFS Meridian US Value WH1 GBP-2.9%-4.5%
MFS Meridian US Equity Income WH1 GBP-2.7%-4.6%
S&P 5003.6%-5.8%

Source: FE Analytics, as of 16 Nov 2018 (GBP)

However, the market sell-off at the start of October saw a reversal in the outperformance of growth funds. The top five funds underperformed both the S&P 500 index and the more value-oriented funds.

So, what has been driving this sell-off? Almost all the top performing growth funds in the sector have exposure to a handful of the Faang stocks (Facebook, Amazon, Apple, Netflix and Google’s Alphabet) which experienced a tough October.

  

Source: Bloomberg, as of 16 Nov 2018 (USD)

Faangs take a beating

October saw the markets punish Apple and Amazon for lowering Q4 forecasts to the lower end of expectations. Despite beating earnings, the market punished Facebook for not delivering on revenue estimates, daily and monthly user growth. Alphabet’s Q3 revenue was just shy of expectations but the stock was down around 5% in extended trading. Netflix surged initially mid-month after the company beat earnings, but still participated in the broader tech sell-off and ended down more than any of the other Faangs as the company announced a $2bn new junk bond offering to fund new content.

With the exception of Facebook, all the Faangs have been strong outperformers this year, in particular Netflix and Amazon. Four out of the five top performing funds listed in the table above hold Amazon as the largest position sized over 9%. It is no secret that these stocks have driven the US market in recent years, contributing to their high valuations. As of October-end, both Netflix and Amazon still trade at a massive premium to the US market, with P/E ratios at 105.0x and 99.0x, significantly higher than the S&P 500 at 16.6x.

As long as this handful of growth stocks continue to outperform the market, funds that invest in cheaper, mispriced stocks will inevitably get left behind, as shown in 2017 and year-to-date. These stocks have advanced with the support of robust earnings rather than only be fuelled by multiple expansion driven by herding behaviour like in the dotcom bubble. The increasing popularity of ETFs have also had an upward effect as these funds are compelled to buy a greater proportion of these narrow subset of stocks. However, there are concerns that both valuations and earnings in general may be peaking after a very strong period. Such wobbles could become frequent in this late stage of the economic cycle.

Most crowded trade

According the to the Bank of America Merrill Lynch Global Fund Manager Survey, being long the Faangs has been the most crowded trade for 10 consecutive months. This partly explains why they were hit the hardest when global markets sold off aggressively in early October.

While this narrow subset of stocks has driven the high valuations of the US equity market, value managers still believe that they continue to find plenty of opportunities. Removing the effects of the Faangs results in a reasonably valued equity market.

So, does the recent rotation imply we are entering value dominance? This is incredibly difficult to predict and certainly costly to time. Research from Boston Partners shows that trying to time the growth to value rotation can be costly. The effect of missing the top ten best days of value outperformance during the first three months of value outperformance has a negative effect on total returns. The table shows that in two of the four instances below, trying to time the rotation actually results in a lower return than if one remained invested in growth itself.

Value Annualised ReturnGrowth Annualised ReturnValue return less top 10 days in first three months
31 Dec 1991 to 4 October 199314.6%0.2%8.8%
2 Feb 2000 to 30 June 20021.1%-26.9%-8.8%
9 October 2002 to 8 February 200719.3%13.4%11.1%
14 September 2015 to 30 December 201613.9%7.3%0.7%

Source: Boston Partners

Tanvi Kandlur is a fund analyst at FE.

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