Is It Rotation Or Risk We Should Worry About?

As we approach the final weeks of calendar year 2019, the global investment community remains as polarised as ever on what to expect next and how best to position portfolios.

According to industry consultant bfinance, large institutional investors globally and in Australia are increasingly opting for a lower risk portfolio positioning, preparing for the end of this cycle and seeking safety through ongoing diversification, including in non-listed assets.

A number of technically-oriented experts on the other hand remain confident equities are set-up for an end-of-year rally, as is usually the case. Market researchers at ANZ Bank published research this week offering further support to this view. For equities, points out the ANZ Bank team, Santa Claus comes bearing gifts more often than not.

On ANZ Bank's historical analysis, Australian equity indices finish the annual holiday period higher no less than 75% of times from where they started it. Their analysis has extended into related currencies and here the picture/correlation seems less clear. The Kiwi dollar (NZD) tends to benefit from the upward bias in equity markets into year-end, but not so much the AUD.

Investors should note: the team at ANZ Bank is of the view that a so-called Phase One deal between the Trump administration and China looks more likely than not. The researchers also believe the annual Santa rally for equities is often but a self-fulfilling prophecy.

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Unsurprisingly, in an environment that looks nearly as polarised as during the opening months of 2016, expert opinion about which sections of the share market are likely to perform best remains equally sharply divided.

While it remains true that laggard stocks, otherwise known as "cheaply priced", have staged somewhat of a come-back since August, with stocks including Nufarm, Lendlease, Janus Henderson and BT Investment making up a lot of ground inside a relatively short window, opinion remains highly divided whether this is simply a direct result of bond yields correcting higher, on top of various idiosyncratic reasons for the sudden resurrections, or whether we are indeed witnessing the early signals of a profound rotation in market leadership?

As most active managers have found 2019 an extremely tough year, following broad underperformances throughout 2017 and 2018, many are hoping there is more substance to this attempted rotation in equities leadership. It would mean active "Value" managers have finally a good story to tell the investors who remained loyal throughout the tough years past.

Their most preferred point of reference right now is Europe where "Value" has significantly outperformed "Growth" as financial markets priced out the prospect of an imminent recession. In Australia, however, re-positioning for a similar switch remains fraught with danger. This much has again be proven by events this month.

One of the prime examples of the dangers in owning cheaply priced laggard stocks in the Australian share market is perennially disappointing childcare centres operator, G8 Education ((GEM)). The stock has looked cheap on numerous occasions throughout the years past, but every time management has found a way to disappoint and to cause yet another pull back in the share price.

G8 Education fell below $2 during the broad-based market meltdown of late 2018. Following its second profit warning in three months, the share price has again sunk below the $2 mark. This is where G8 Education shares were trading at in early 2013, nearly seven years ago.

In contrast, a lot of market attention and commentary has been spilt on the fact that smaller cap technology stocks have lost a great deal of their gains in recent months. Even so, on Monday one of the most doubted in the local sector, Appen (APX), increased guidance for the year and its shares have shot up no less than 13% in an overall down market.

Irrespective of active funds managers' desire to see yesterday's winners turn into losers and vice versa, the simple observation remains that for many of those market outperformers the operational momentum continues to look favourable, while making similar assumptions for laggard stocks remains fraught with danger.

Last week I wrote about how current market dynamics continue to favour CSL (CSL) in the global blood plasma market. Aristocrat Leisure (ALL) and TechnologyOne (TNE) have yet to report their FY results, but analysts remain convinced both can continue growing at double-digit percentage speed in the years (multiple) ahead.

Last week, highly priced Xero (XRO) managed to once again beat market expectations. Macquarie Group's (MQG) FY results release the week prior was universally well-received, as was James Hardie's (JHX) quarterly update.

In contrast, three of the five banks that reported in recent weeks (excluding Macquarie) cut their dividend and had very little optimism to share for the year ahead. The attempted surge in the BlueScope Steel (BSL) share price was promptly met by analysts downgrading their recommendation for the stock (indicating they do not believe it is sustainable nor warranted).

I could cite many more examples, but I think the general observation stands: this is a share market heavily polarised because certain segments are enjoying strong operational momentum, and other segments are not. The difference between these two extreme opposites -and let there be no misunderstanding: the difference in operational dynamics are opposites into the extreme- are reflected in equally opposing valuations; "expensive" versus "cheap".

It is not impossible to imagine a scenario whereby the switch of investor funds flow out of "expensive" outperformers into "cheaper" underperformers can gain more traction and build genuine, lasting momentum. Continued bond market weakness (rising yields) will do exactly that, up until a point where it becomes a negative for all segments of the share market.

Genuine progress in the on/off negotiations between the USA and China, which might prompt expectations for economic growth in 2020 to rise substantially, is another factor that can further stimulate such market switch.

An economic recession however, the elephant in the room, will reduce growth for those that are growing and thus make share prices look bloated while those with no growth will increasingly be at risk of issuing the next profit warning.

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Investors are conditioned to look for earnings growth and sustainability of dividends but sometimes the key story lies within the market itself.

Equity strategists at JP Morgan remain convinced market momentum is starting to turn in favour of cheaper priced laggard stocks and an important factor in their forecast is the observation that market positioning has once again reached extreme polarisation. In line with trends observed by bfinance, JP Morgan strategists find the current bull market has been built upon investors favouring "risk off" portfolio positioning.

In practice, this means most of global funds have flowed into defensives such as infrastructure owners and lower-risk bond proxies, as well as in ever-reliable healthcare stocks and other structural growth stories.

If these investors are given enough confidence to take on more risk, a savage rotation a la late 2016 should be on the cards.

Such a scenario, of course, requires a different economic and geopolitical context and, indeed, it is JP Morgan's forecast that global economic momentum is turning already. By this time next year, the global economy will be experiencing its third wave in this cycle which shall see growth recover to above trend. At least, such is JP Morgan's forecast.

To underline the conviction behind their outlook, JP Morgan strategists in Australia have made several key changes to the broker's Model Portfolio; Financials have been upgraded to Overweight, Healthcare has been downgraded to Underweight and the existing exposure to Materials has been pushed further into Overweight. Inside "Materials" ("Commodities") the strategists in particular like Energy.

Another observation that features prominently in the JP Morgan outlook for 2020 is that the relative valuation differential between the polar opposites in equities has fully blown out beyond two-standard deviations from the 15-year average. Equally interesting is the observation that, in between the battle between "Growth" and "Value" in global equity markets, the ultimate outperformance has been achieved by "Quality" (as can be witnessed through the performance of CSL in Australia).

The underlying view is that "Value" has a lot further to rise in the months ahead (at least including Q1 next year, predict the strategists) and that the switch in relative momentum will become too large to ignore for professional investors, which then becomes a self-reinforcing momentum process.

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It probably won't surprise the JP Morgan outlook for the year ahead is not widely supported. Plenty of experts around who believe economic momentum is deteriorating instead and in Australia there won't be a positive impact on consumer sentiment and spending because the recovery in housing is driven by foreign inflows from Hong Kong and China.

Strategists at Morgan Stanley offer an alternative view. They too believe the underlying trend is improving for the US economy, but contrary to JP Morgan they don't believe the recovery will be strong enough to continue this bull market for equities. Morgan Stanley has long held the view (since early 2018) there is no fundamental justification for the S&P500 index to sustainably trade above 3000. This forecast has been upheld.

The updated view now is that US risk assets (technology stocks on the front row) will prove too expensively priced for the pending pick up in economic momentum. It is their view investors will instead seek to achieve returns through rotation. Value is expected to outperform Growth.

Globally, Morgan Stanley recommends portfolios should be market neutral at best as far as equities are concerned, but in the US the recommended allocation is heavily underweight, with above average levels of cash and government bonds. Copper is preferred above oil and gold.

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In Australia, for self-managing investors who shouldn't be concerned about outperforming or underperforming the index on a short term horizon, the main focus is probably best kept to avoiding booby traps and torpedoes.

The prognosticated return of "Value" as a winning strategy might look appealing, if it proves sustainable, in daily reality vulnerable Australian companies are still issuing profit warnings, with direct consequences for share prices.

On Monday, as I am writing this Weekly Insights update, this tangible risk was again put on investors' radar by Coronado Global Resources (CRN) -profit warning pushed the share price to its lowest level since IPO- and by Monash IVF (MVF) -profit warning- by Smartgroup Corp (SIQ) -profit warning and CEO exiting- and by Prospa Group (PGL) -profit warning while the IPO was only five months ago.

In line with my earlier analysis and observations, I believe there are good reasons in many cases as to why share prices look "cheap" in Australia. The least desirable way to find out is through another bad news announcement which triggers instant share price shellacking. Better to be warned and act accordingly.

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