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Apr 09 2018


  • Apr 9, 2018

Investors often face quandaries. Always present is whether the markets will rise or fall? Currently, a few perplexing issues are interesting and deserve some pondering. Is new leadership evolving in the stock market? Should you buy regulated or nonregulated FANGs? Why are energy stocks doing so well in Emerging Markets and so poorly in Developed Markets? Finally, what is the bond vigilante saying about the risk of a crisis? 

New Leadership For The Balance Of This Bull Market?

With technology stocks recently struggling, many wonder if leadership is changing for the balance of this bull market? The economy is increasingly being led by business spending and if this trend continues, we suspect this new economic character will be exemplified by the stock market. 

Chart 1 overlays the ratio of real business spending relative to consumer spending since 1950 with the relative performance of capital goods stocks (comprised by the technology, materials, industrials, and energy sectors). At least since 1950, the relative performance of capital goods stocks (those most sensitive to business spending) have done best when business spending is leading the economy, and have often underperformed when the economy was driven primarily by consumer spending. 

As illustrated, until the 1990s, the relative performance of capital goods stocks closely followed both the direction and magnitude of the business/consumer spending ratio. Since 1990, although the magnitude of movement has differed, the direction of capital goods stock leadership has continued to mimic spending trends in the economy. In the last few quarters, the overall economy has been led more prominently by business spending, and for several reasons we expect this trend to continue. First, profits are poised to rise significantly this year and corporate liquidity remains remarkably prevalent. Second, capital spending has been weak throughout this recovery and pent-up demand is probably significant. Third, the U.S. economy has returned to full employment, raising labor costs and increasing the need for productivity-enhancing spending. Finally, for the first time in this recovery, global economies are in a synchronized expansion, forcing firms to increase capacity simply to keep up with improved demand. 

While defensive stocks may do best until the stock market finds a sustainable bottom, investors should consider overweighting capital goods stocks for the next leg of this bull market.

Regulated or Nonregulated FANG Stocks?

Recent troubles at Facebook regarding the selling of collected user information to third parties has intensified an issue which has been looming for the last several years. Should consumers be protected from companies selling their online activity histories? That is, do some internet companies require increased regulation? 

This issue is important for technology investments, particularly for those widely-popular FANG stocks. Should investors interested in FANG stocks buy the overall index or just the “nonregulated” FANGs? Currently, there is no official distinction recognized among FANG stocks, as far as those which are regulated and those which are not. Nor do any regulatory changes appear imminent. However, stocks comprising the FANG index have been acting as though regulations are already in place and investors should be aware of how different the performance has been between “regulated” and “nonregulated” FANGs!

The NYSE FANG+ stock price index includes ten of the most popular, highly-traded technology and tech-enabled companies. Chart 2 divides this index between those companies whose primary business revenue comes from selling collected user information to third parties (FB, GOOGL, TWTR, and BIDU) labeled the “Regulated FANG Index,” and those whose primary revenues come from product sales or services (AAPL, AMZN, BABA, TSLA, and NVDA) referred to as the “Nonregulated FANG Index.” While all ten stocks are extremely popular investments, the distinction is between those who sell customer information (and therefore may someday face stiffer regulations directly impacting their business models) and those who have a more traditional goods and services profit model. Arguably, ten stocks are a small sample size, all these companies may sell customer information, and this distinction is not based on any scientific approach but rather a simple qualitative selection process. However, this approach divides the FANG+ index nearly in half (four stocks in regulated and six stocks in nonregulated) and produces two stock indexes with significantly different performance results since 2014.

Since the end of August 2014 (the first month the data for all ten stocks was available), the nonregulated index is up more than three-fold while the regulated index is up only slightly (shown in Chart 2). Moreover, their divergent performances have not just been since technology recently began to struggle, nor since the recent Facebook news became widespread. Rather, as shown in Chart 3, nonregulated FANGs have been besting regulated FANGs persistently and by a wide margin since the third quarter of 2014!

Even though the issue of increasing regulation in this industry has only recently become acute, the stock market has seemingly been discounting this potential risk for some time. Perhaps, if you want to participate in the biting edge of popular technology, you should consider buying the “nonregulated FANGs” rather than the overall index?

Emerging Energy Good … Developed Energy Bad?

Energy stocks are widely considered losers in recent years. However, this is mainly due to their poor performance in Developed Markets (DM). In Emerging Markets (EM), energy stocks have fared much better. Indeed, during the last four years, in U.S. dollar terms, the MSCI EM Energy sector has been about flat compared to about a 25% decline for the MSCI DM Energy sector. And this trend has continued into 2018. 

As shown in Charts 4 & 5, year-to-date, energy stocks have been the second best performing sector in Emerging Markets while they have been the third worst performer in Developed Markets. Moreover, this year, DM energy stocks are off by about 6% whereas within EM they are up by more than 6%! Finally, the diverse investment character of EM and DM energy stocks is highlighted by an extremely low correlation. Since 1998, the correlation between the daily percent changes in Emerging and Developed Market energy sector stock price indexes has averaged only 0.56.  

We are not sure why Developed and Emerging Market energy stocks perform so diversely. Perhaps it reflects currency movements, a different composition of energy businesses or maybe it reflects a disparate importance of energy overall within DM and EM economies. Whatever the reasons, “where” to invest in energy stocks may be just as important as “when” to invest. Chart 6 offers some insight into this quandary?

It compares the price of crude oil with the relative price of Emerging to Developed Market energy stocks. Two things are immediately obvious. First, EM energy stocks do best when crude oil rises and DM energy stocks outperform when the price of crude declines. Therefore, investors with favorable outlooks for the energy industry should not just overweight energy stocks but rather tilt toward EM energy stocks. Likewise, DM energy stocks should predominantly be used for underweighted positioning in the energy industry when oil prices are expected to decline. Overall, Emerging Market energy stocks are bullish energy plays and Developed Market energy stocks are primarily defensive investments. 

Second, from a few months to about one year, the relative performance of EM to DM energy stocks has consistently led movements in the price of crude oil. As shown, EM relative performance bottomed ahead of the price of crude oil in late-1998, late-2001, in 2008, and in 2015. Similarly, EM energy relative price peaked prior to a subsequent top in the price of crude oil in early-2000, early-2004, early-2006, early-2008, and in early-2011. Consequently, the performance of EM energy stocks has provided a good guide to the likely direction of crude oil prices. Currently, the significant outperformance of Emerging Market energy stocks since late last year suggests the price of crude oil is poised to rise higher than most expect in the next several months. 

The Bond Vigilantes’ 50-Year Crisis Chart?

Everyone has their favorite recession/crisis/end-of-bull-market indicators. Many focus on the yield curve, evidence of excessive economic behaviors, a significant widening in credit spreads, or an aggressive demeanor from policy officials. Perhaps the best indicator is far simpler—bond vigilantes!

As Chart 7 shows, a simple rise in bond yields has been an excellent signal for every major financial/economic event during the last 50 years. When yields rise sharply, or sometimes just persistently for a period, bad things happen. The quandary is what yield level and/or for how long can yields climb before something blows?

During the last couple years, the ten-year bond yield has more than doubled, rising from its low of about 1.35% during this recovery to recently reaching about 3%, its highest level in almost seven years! Although yields have risen smartly for some time now, most still perceive them as quite low and hardly at a level which would threaten either the recovery or the stock market. However, is this glass half-full thinking? Should the ten-year Treasury yield rise above 3% yet this year, the size of the rate hike over the last couple years and its duration would be on par with similar periods in the past which led to crisis. A rise in the ten-year yield of 2-ish% over 2-ish years is comparable with many past pre-crisis bond markets.

Nor do yields have to rise to “new recovery highs” before they bite. As shown in Chart 7, in every instance since 1980 the yield peak leading to the next crisis was lower than the previous crisis peak. The ten-year yield peaked at about 7% just before the dot-com meltdown and at a little over 5% before the 2008 crisis. If a yield peak even as low as 3.5% leads to a crisis, the last circle in Chart 7 would appear perfectly normal compared to past crises.

Perhaps we are closer today to a crisis-invoking ten-year bond yield than most appreciate? While a variety of risk indicators should always be monitored, don’t ignore the bond vigilante and its excellent 50-year track record!

Quandaries are Tough!

Facing dilemmas is at the heart of investment management. Will it go up or down? Is that serious or not? Should I veer right or left? Overweight or underweight? Quandaries make investing fun and are also the worst thing about investing. Often these perplexing choices are made only by default through indecision and inaction. Never is there certainty, and the correct answer is known only after the fact. Sometimes, you don’t even know you face a quandary. Who knew energy stocks performed so differently in Emerging and Developed Markets, or that effectively you’ve had a choice to buy regulated or nonregulated FANGs? Mostly, they are just tough calls. Do I stay with my tech winners or diversify more broadly across capital goods sectors? And, your response to a single quandary may prove the most important call of the entire bull market. Has the ten-year bond yield risen by enough for long enough to end this cycle?

About The Author

James Paulsen / Chief Investment Strategist

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