The best sectors late cycle in a bull market

James Gerrish

The current bull market is now the longest in history, so not surprisingly the main question we are regularly being asked is, what now?

The broad-based US Russell 3000 index has advanced ~350% since the nadir of the GFC, significantly more than our own ASX200. Overall this should be no great surprise to investors given we don’t have stocks like APPLE, Google and Amazon in the Australian index, and that’s where the growth in earnings have largely come from.

When we stand back and look at the strong advance by US stocks, there is evidence that a potential correction is close at hand, although no clear sell signals have yet been generated.

  1. US stocks experienced 2 multi-month corrections is 2011 and 2015/6, in both cases investors were given a warning before the major pullback – January / February earlier this year “feels” like yet another warning.
  2. Following both warnings, it took 3 & 4 quarters respectively before stocks finally topped out implying a major top may not be reached until 2019.

US Russell 3000 Chart

The availability and cost of money has been a significant driver of this bull market for stocks.

Low interest rates coupled with quantitative easing (central banks printing money to buy assets) has been a dynamic force behind asset prices.

As we came out of the GFC, the ‘Bernanke Put’ was a term often used to describe the then US Federal Reserve Chairman Ben Bernanke’s 1-wood approach to supporting the market. By aggressively printing money and purchasing bonds he increased overall liquidity (availability of $$) and ensured interest rates (bond yields) stayed low, meaning money was cheap. The notion that while markets had a free put option from central banks, then buying assets made sense, and the bull market gained steam.

Quantitative Easing has now been wound back and interest rates have subsequently bottomed changing their influence on equities from tailwind to headwind.

While history tells us that the “canary in the coal mine” for stocks is very often rising interest rates, the differential between yields also provides a significant clue to the future for stocks.

  • The interest rate differential between US 2 and 10-year bond yields has narrowed to 0.2202% as the US Fed hikes interest rates - see below chart.
  • We believe the current momentum will have the yield curve inverted by late-2019 / early 2020 i.e. 2-year bond yield will be above that of the 10-years.
  • Only once has the inversion of the yield curve not been a precursor for a recession and hence a major correction by stocks.

US 10/2-year bond yields Chart

While we unfortunately don’t have a crystal ball, from a risk / reward perspective we are fairly confident of the below 2 points:

1. Global equities next meaningful correction will commence in the next 12-months. 2. The above-mentioned pullback for stocks will probably be between 15 and 20%.

The best sectors late cycle in a bull market

As we saw last week the more traditional “blue chip” stocks can often hold together when the market is weak, particularly the areas that have already been re-priced down as a consequence of stock / sector specific issues, like the banks. While the high valuation / growth stocks that have performed for the last few years become the most vulnerable.

When we consider history one of the standout messages for this stage of the cycle is be extremely careful paying up for growth i.e. We want GARP (growth at reasonable price) not GAAP (growth at any price).

To keep things simple (KISS) it’s time for the below:

  1. Seek – solid / predictable profitability (ROE – return on equity) with relatively low debt levels at of course a reasonable price / valuation.
  2. Avoid – high valuation growth stocks that are often unlikely to live up to expectations / hopes if the economy becomes a major headwind.

MM believes the time has arrived for the “boring quality blue chips” compared to the growth stories that have excelled over the last few years. Interestingly, the Telco Sector usually outperforms in bear markets and Telstra (TLS) has already started to rally this financial year in a falling market.

The ASX200 has experienced 2 decent corrections since the GFC:

Firstly, in 2010/11 the market retraced 25% with the US debt downgrade causing the market panic in August 2011 which actually fuelled the capitulation which ended the drop.

Secondly, in 2015/16 the market retraced 21.5% with August being the panic month again, on the 24th in 2015 the Dow opened down 1000-points, the Chinese devaluing their currency was regarded by many as the main cause of the large decline.

This time we are looking for the eventual decline to be caused by old fashioned economics i.e. global central banks turning off the “free money” tap - we are already seeing the impact of tighter credit on the Australian property market and it’s not pretty.

The recent sharp decline in February was sparked by bond yields rising but we believe that was just a warning of what’s in store moving forward.

  • When interest rates rise, the financial sector usually benefits as margins rise – assuming we don’t experience a crash in asset prices leading to large bad debt provisioning. Also, when we look beyond the financials, historically the consumer discretionary and consumer staples sectors perform solidly, again assuming central banks manage to increase interest rates without pushing economies into a recession.
  • Conversely, we believe the major risks rest with the likes of Afterpay Touch (APT), WiseTech Global (WTC), Appen Ltd (APX) and Xero Ltd (XRO) – stocks that have enjoyed huge upside momentum on the back of top line (revenue) growth and massive P/E expansion. Unfortunately, investors forget very quickly, in the last 2-months both Facebook and Netflix have fallen well over 20% illustrating the dangers of growth stocks at this stage of the cycle.

How and when to diversify?

The initial and very simple / short answer here – now!

From a risk / reward perspective, even though no clear sell signals have been generated, we believe it’s time to position portfolios to a more defensive stance.

Buy - The banks, Telcos, Wesfarmers & Woolworths and conservative hybrids i.e. good yielding ex growth stocks.

Sell - High valuation growth stocks (other examples SEK, REA and CAR), real estate and utilities i.e. expensive growth stocks and stocks that are negatively influenced by rising interest rates.

Reduce - Healthcare stocks.

Stocks to buy & avoid

The press has been enjoying telling its readers that the ASX200 is making fresh decade highs, but as is often the case its only half the story.

When we include dividends the local share market is actually soaring to fresh all-time highs.

Over the long-term, the stock market has proven itself to be an excellent form of investment, especially when dividends are compounded. The brave who bought local stocks directly after the GFC have more than tripled their money, significantly outperforming that much heralded beast “property”.

Now is the time to invest smarter with one eye clearly on downside risks i.e. keep your finger firmly on the pulse.

A portfolio of the underperforming “old style” stocks looks ready to outperform if managed correctly. These generally higher yielding almost ex-growth stocks can also be combined with some hedging to generate yield, and protect capital.

Actionable insights today

While markets now seem to be stretched, money remains on the table for the informed.

Some alternatives:

  1. A portfolio of hybrids can be relatively insulated from the underlying share market when specifically selected.
  2. A portfolio of high yield old fashioned blue chips managed actively can yield well over 5% while this can be partially or fully hedged using ETF’s.
  3. Investors can even skew portfolios to be net bearish i.e. benefitting from a market decline

BetaShares Bearish ASX ETF (BEAR) Chart

Conclusion

  • MM believes the time has arrived to reposition portfolios with a late cycle bias i.e. away from high valuation / growth stocks.
  • Importantly, keeping a finger on the pulse will be key as markets ultimately find a top

Want to learn more?

Market Matters publishes daily market reports and sends SMS alerts when we transact on our portfolio. To get our latest market views and hear when we take new positions, trial Market Matters for 14 days at no cost by clicking here.


Comments

Please sign in to comment on this wire.
Medium c8e9ebbccb90d6d55b13b7ac2a21cbae1383028176

Graeme Holbeach

This whole article appears to revolve around Para. 4 in which you state that , "US stocks experienced 2 multi-month corrections is 2011 and 2015/6, in both cases investors were given a warning before the major pullback ." Could you explain what these warnings actually were. The orange and pink circles on the Russell 3000 chart mean nothing to me.

Avatar fallback

Carol Green

What "specifically selected" hybrids would you recommend? C Green

Avatar fallback

Justin Baiocchi

"The orange and pink circles on the Russell 3000 chart mean nothing to me." I'm no chartist, but I think the orange circles show an intra-month high above the monthly open price, but an end of month close below the open. Typically seen as a sign of market weakness I think.

Avatar fallback

Nigel Stemson

Re warnings, I simply see the Orange circle as a "top", immediately followed by a low that has broken an uptrend, and then a few monthes later a new "top" (Red circle) which is followed by a larger decline in the index

Avatar fallback

Rash - IIR

Mate that is some serious Research undertaken by you on this piece - great stuff!

See 2 more comments