As more speculative investing is once again driving returns, Portfolio Manager Justin Tugman discusses market factors that could encourage a renewed focus on fundamentals.
- Following a brief period of market rationality, more speculative investing is once again driving returns; however, we see developing factors that may contribute to a renewed focus on fundamentals.
- For one, inflation may prove more persistent than many expect – particularly wage growth as companies compete to attract and retain workers.
- Economic and earnings growth may also look less rosy in the coming year compared to the artificially supported levels of early 2021, tempering investor euphoria and bringing valuations back into focus.
The second quarter of 2021 began with the same fundamental-driven investing we saw at the end of the first quarter, as investors again focused on the importance of company valuations, profitability and quality. Steady progress on vaccine distribution, increased economic reopening and hopes for a broad-based recovery all favored more cyclical and commodities-driven companies, which tend to make up a much larger portion of value benchmarks relative to their growth counterparts. Likewise, higher inflation expectations, rising interest rates and a steepening yield curve helped propel interest rate-sensitive financial industries such as banks higher.
A Return to Irrationality
While the last few months favored value-focused investors, the market changed course in May as extreme euphoria and speculative investing again drove returns ‒ a trend that has since continued. Several factors contributed to this rotation: Long-term interest rates, which had been driven up by higher gross domestic product (GDP) growth and inflation expectations, began to fall. Another round of federal stimulus payments also reached consumers even as the economy started to reopen. This fueled speculative short interest covering ‒ an indicator of optimistic sentiment ‒ with investors seemingly indifferent to poor company fundamentals and/or high valuations.
We witnessed many of the same excesses we saw in January during the second quarter, with high beta stocks outperforming low beta and money-losing companies outperforming earners. As “story” stocks with no earnings again rallied, high-quality value stocks found less favor with investors in this setting.
Navigating a Changing Environment
Throughout this market rotation, the path of economic recovery has also evolved, impacting companies across multiple sectors. The energy sector in general has rallied given increased global demand from the recovery and rising commodity prices, with the most highly leveraged and lower-quality names within the group experiencing outsized gains. Other companies have faced challenges in a newly inflationary environment. For instance, some companies in the consumer discretionary sector have struggled with higher input and labor costs and faced lags in adjusting their prices to account for higher operating expenses.
Conversely, other consumer-oriented stocks have benefited as employment and income growth have boosted retail spending. Within the industrials sector, we have seen a continuation of reshoring ‒ a trend accelerated by the pandemic ‒ as companies impacted by supply disruptions and trade uncertainty have looked to create redundant capacity closer to home.
What Could Encourage a Return to Fundamentals?
As the economic recovery progresses, it has been frustrating to see a rational market driven by fundamentals devolve into a renewed period of irrationality, but it has not shaken our belief in the importance of following a disciplined investment strategy. Quality matters over the long term. Earnings, free cash flow and balance sheet strength – not social media campaigns – ultimately determine a company’s value.
Periods of irrationality can end just as quickly as they begin, as speculative investors in the tech crash of the 2000s learned to their detriment. While we don’t believe in trying to predict the timing of market shifts, we see several factors that may contribute to a renewed focus on fundamentals. For one, we believe inflation may prove more persistent than many expect, especially if companies are forced to pay higher wages to attract and retain workers. This wage inflation could, in turn, lead to more widespread inflation throughout the economy.
Historically, periods of higher inflation have rewarded value investing over growth. The resulting upward pressure on interest rates would also benefit more interest rate-sensitive investments such as banks, which are heavily weighted in value indices. However, we would caution that 2022 economic and earnings growth may look less rosy when compared to the levels of early 2021, which were artificially supported by tremendous monetary and fiscal stimulus, and this could temper investor euphoria.
Above all, we believe periods of volatility ‒ where valuations often don’t seem to make sense ‒ may present investors with opportunities to invest in high-quality companies at attractive valuations.
Value investors search for companies that they believe are undervalued by the market, and therefore expect their share price to increase. One of the favored techniques is to buy companies with low price to earnings (P/E) ratios. See also growth investing.
Gross domestic product (GDP)
The value of all finished goods and services produced by a country, within a specific time period (usually quarterly or annually). It is usually expressed as a percentage comparison to a previous time period, and is a broad measure of a country’s overall economic activity.
The analysis of information that contributes to the valuation of a security, such as a company’s earnings or the evaluation of its management team, as well as wider economic factors. This contrasts with technical analysis, which is centered on idiosyncrasies within financial markets, such as detecting seasonal patterns.
A graph that plots the yields of similar quality bonds against their maturities. In a normal/upward sloping yield curve, longer maturity bond yields are higher than short-term bond yields. A yield curve can signal market expectations about a country’s economic direction.
The rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures. The opposite of deflation.