By Kevin Wong, Senior Portfolio Strategist
Since we wrote the last article, calling it a time to reflect and to take some profits on US equities, the S&P 500 has powered above the psychological 3000 mark. Driving that rally was a rotation into “Value” stocks (Energy, Financials, Industrials) which also resulted in “Growth” stocks underperforming (Technology, Healthcare, Communication Services and Consumer). We admit it was not a great feeling.
The game is tied for 2020 if you are mainly invested in US equities (even better if you are mostly invested in Technology shares). While the S&P 500 has recovered all its losses since the year started, not all equity markets have had the same fate - Emerging Markets and European shares are still lagging (both playing into “Value”).
The “rotation into value” debate: There has been more misses than hits over the last decade with regards to any investment call for “Value” outperforming “Growth”. In recent years, the periods of outperformance have also been short-lived. However, there have been a few positive developments that could be supportive of a modest tilt towards “Value”:
1) the PMI recovery in May, while still depressed, is a dramatic improvement following its collapse in March and April;
2) the encouraging US payrolls report last week suggest perhaps some growth re-acceleration;
3) the ECB easing its monetary policy more than expected, increasing its quantitative easing program and extending the program by another six months (this is supportive for Europe);
4) US long-end rates have moved decisively higher over the past week and the Dollar Index has moved decisively lower (the latter is supportive of Emerging Markets in general).
Recognizing the pros & cons. This rotation that saw an outperformance in “Value” against “Growth” started since the middle of May. Perhaps this rotation to “Value” has additional legs. Meanwhile, the risk of another increase in the rate of virus infections still exists, as do the risks related US-China tensions and the November US Elections. In addition, our guess is that there appears to be some hopes being placed on a vaccine by year end (is this too aggressive?).
You will need a stop loss or a hedge for this trade: We are probably stating the obvious here, but the “Value” trade usually begins with a call on valuation being cheap coupled with some form of conviction on a recovery in economic datapoints (which in this case, one of the risks is a second lock-down for economies that have started re-opening). Here is the issue: that same argument related to valuations being attractive, has the risk of keeping you in the trade even if your expectations of a recovery prove incorrect (because it is still cheap!). But if we acknowledge that this is just “a trade”, then it is important to have a stop loss or a downside hedge, because the last thing you want is to be caught in that value trap.
Our Strategy: We are not retracting the concerns that we have cited previously; after all, the profits that were locked in, were taken from “Growth”. We are already invested in Emerging Markets, but we do see some merits for a slight tilt towards Europe and certain sectors such as Financials and Industrials (areas where we are currently under-invested in versus the benchmark). Nevertheless, we believe this represents a short-term trade and one that requires some form of a hedge. In this regard, call options on “Value” segments/sectors could be an alternative way to implement this strategy. Finally, as we wrote the last time, we are definitely watching the recent weakness in Gold with keen interest.