The Times They Are a-Changin’
Come writers and critics
Who prophesize with your pen
And keep your eyes wide
The chance won’t come again
And don’t speak too soon
For the wheel’s still in spin
And there’s no tellin’ who
That it’s namin’
For the loser now
Will be later to win
For the times they are a-changin’
“The Times They Are a-Changin’”1
We believe that the times are most definitely “a-changing'” for the markets. One of the central tenets of Balentine’s investment process is the idea that markets move in cycles that last for some duration and then mean-revert. Up until the early months of the coronavirus pandemic, much of the market strength was in U.S. Large Cap Growth. At times, there have been pockets of strength elsewhere, both globally and in equity style, but for the most part, market strength has been in technology and associated stocks. During the U.S. Large Cap Growth regime from 2013 to the middle of 2020, Growth stocks were up 241% (18.8% annualized) while Value stocks were up 68% (7.6% annualized). However, at the end of August 2020, that changed. As we point out in our 2019 Capital Markets Forecast, capital markets tend to move in advance of the economy; it was at this time that capital markets began to anticipate the baton handoff in economic drivers from industries that had been powering the economy to those that theretofore had not. As we sit here 18 months from that seminal moment, trend changes are apparent. Of the aggregated equity styles we monitor, only U.S. Small Cap Growth equities have performed worse than U.S. Large Cap Growth equities. A change in regime seems to be at hand. What are notable data we are seeing within this great shift?
Areas Signaling a Regime Shift
- Declining Tech Stocks. The big tech stocks had been acting as a strong defense while the overall market declined and a strong offense when the overall stock market was rising. Now, they are not acting as defense or offense. Additionally, FANMAG² stocks had been moving in sync like an asset class. Now, there is a large divergence within these stocks as each one trades on specifics idiosyncratic to each company.
- Rising Bond Yields. Bond yields are rising all over the world; in fact, for the first time in the era of Quantitative Easing (QE), bond yields are rising during a market correction. This is significant because it indicates an expectation that inflation will continue to increase.
- Value Outperformance. Value continues to outperform Growth even with the yield curve flattening. As we mentioned earlier, from 2013-2020, Growth stocks, typically those in technology, had been outperforming Value.
- Commodities Outperformance. Commodities are outperforming U.S. equities, most notably oil. Additionally, gold has begun to rise even as real interest rates are rising. This is important because it reflects a higher probability of a longer-duration inflationary environment.
- Global Equities Outperformance. There are small signs of nascent short-term performance in global equities over U.S. equities. Importantly, global bank stocks are acting bullishly more so than we have seen at any time in the 15 years since the Global Financial Crisis.
Since the beginning of the bull market in 2009, we have observed similar phenomena. However, this is the first time in this period that we have seen all these trends simultaneously. To us, this signals new dominating asset classes and companies; there is a new sheriff in town. This is healthy for the market, as the key for an enduring bull market is strong breadth and rotation in leadership.
There is a lot to digest in these data points, but our main takeaway is that much of what has worked over the last many years is likely done for awhile. Or as Mr. Dylan said: “For the loser now will be later to win.”
Examples of Regime Shift
1. The Decline of Tech and FANMAG Stocks
We believe this era of buying some combination of 1). the biggest market cap tech stocks as the “new utilities,” and 2) the smaller-sized, highest growth “innovation” stocks and watching the “free money” just roll in is over. Consider the outperformance of U.S. Large Cap Growth stocks over U.S. Large Cap Value stocks in the years leading into the coronavirus pandemic peak at the end of August 2020. Tech companies experienced steep growth from 2013-2020. Since August 2020, however, their value has started to drop gradually. This behavior mirrors that of internet companies from 1999-2000, which grew quickly, declined precipitously, and remained stagnant for several years. Updating an exhibit we have shown in recent months, Figure 1 illustrates this parallel by plotting the value of the ARK Innovation ETF (ARKK), which includes some of the more speculative and higher growth companies (e.g., Tesla, Zoom, Roku), from 2020-2021 and the NASDAQ, which reflects the internet companies of twenty years ago, from 1999-2000.
Figure 1 NASDAQ 1999-2000 vs. ARKK 2020-2021
Some insinuate that the worst is in for these stocks, but we think this may not be the case. While the trajectory of the decline has likely seen its steepest slope, now may come the more difficult phase: continual false starts as more and more investors become disenchanted with the space (Figure 2).
Figure 2. The potential template for the smaller-sized, highest growth ‘innovation” stocks
Source: FactSet and Balentine
2. Rising Bond Yields
We believe this era of buying some combination of 1). the biggest market cap tech stocks as the “new utilities,” and 2) the smaller-sized, highest growth “innovation” stocks and watching the “free money” just roll in is over.
It is no great secret that bond yields have risen sharply to start 2022. But somewhat unknown is:
- The start to 2022 was not the start of a trend but rather a continuation of the trend that has been in place since that seminal date of August 2020 (Figure 3)
- This is occurring outside of the U.S. as well (Figure 4)
The implications of this are important. While we continue to expect bond yields to fall during bear markets, we do not expect it is a given they will fall during bull market corrections. Look to the experience so far in 2022, in which bond yields have risen sharply while stocks have corrected, as an example. We suspect this could be the new template for a while, certainly while inflation continues to rear its ugly head.
If bond yields continue to increase, it will certainly impact the equity market, but not necessarily as many may think. Common wisdom says that rising yields will necessitate overall weakness in the equity markets, but we think this idea is misguided. Rather, we propose that there will be groups of stocks that will struggle, but to suggest the entire market cannot succeed is an overgeneralization; we can point to prior periods of rising interest rates where pockets of the market fared well. For example, relative success for energy, financials, materials at the expense of longer duration equities in tech began at the same time as the interest rate trend, August 2020.
Figure 3. Current interest rate trends have stealthily been in place for 18 months.
Source: FactSet and Balentine
Figure 4. Many global developed bond rates were negative a year ago; however, now much of the yield curves are positive.
Source: FactSet and Balentine
3. Despite looming interest rate hikes and a defensive market posture, the U.S. dollar has stalled and started to roll over
Economic theory suggests that the value of domestic currency should rise along with interest rates as capital flows to the higher-yielding country. However, this is often not the case, and we are seeing signs that the U.S. dollar is not playing ball this go around either. It is not outlandish for the dollar to decline in value; since 2009, we have had four declines in excess of 10%. However, what makes this different is the weakness we are seeing when there are twin tailwinds in the form of a rising rate environment and fear in the equity markets. The implications of this trend could affect numerous asset classes positively including international assets, commodities, and Value stocks.
We believe that weakness in technology stocks, rising bond yields, and outperformance in Value stocks, commodities, and global equities show there is a paradigm shift ongoing in the market. With many recent market headlines (outside of Russia/Ukraine) concerning the FANMAG stocks, investors would be excused for thinking the divergent price action within the group (point #1 above) is the most important story of the year so far. In our opinion, this divergence is more a consequence of the real story: investor preferences are changing because of changes in the big picture. As we said earlier, we do not think this is a call to sell stocks en masse. There are always plenty of reasons to sell stocks, and bull markets power through those (in fact, our next market commentary will expound upon this). Rather, we think this is merely a leadership change in the next phase of this epic bull market, a change that is occurring with some transition pain in certain areas. Our investment portfolio is keyed into the areas receiving the baton, not those handing it off, which we hope will bode well as the next phase of the market carries on.
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