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How to play the great reopening

Bryan Dooley of LOM (File photograph)

Despite some recent choppiness, stock market averages continue to hover near their all-time highs – but that masks a subtle shift occurring beneath the surface. Lately, cyclical stocks, or those most dependent on economic strength for profits, have been consistently outperforming growth stocks.

In 2020, investors were rewarded by playing defence as dependable growth stocks massively outperformed economically sensitive issues during the worst months of the pandemic. Over a large part of 2020, consumers stayed at home either by choice or in compliance with government mandated mobility restrictions. The “stay at home” theme favoured more innovative growth sectors such as internet-based e-commerce, tele-health and digital streaming. But that trend has suddenly reversed in a shift which could continue on for a while longer.

Market practitioners know that stock prices tend to lead economic results by up to six months. In this case, even though the global economy has not fully recovered from last year’s recession, many of the hardest hit sectors of the market have already rebounded sharply. As vaccines continue to be rolled out and the news flow on Covid-19 cases and deaths becomes increasingly positive, further progress is likely.

Value stocks are typically more closely tied to economic activity than growth stocks. Mature companies in slower growing industries tend to trade at lower price multiples of earnings and cashflow, placing them in the value category. In contrast, higher growth companies typically command premium prices as investors expect these companies to grow earnings and cash flows faster.

Since the beginning of the year, the Russell 1000 value index is up 14.1 per cent versus just 1.3 per cent for the Russell 1000 growth index, representing outperformance of 12.8 per cent, as of this writing. The most economically sensitive sectors, including energy, financials and small cap stocks have performed substantially better than the market on the back of improving global growth prospects.

Given the high efficacy of our vaccines, distribution rates and inoculation percentage levels are key statistics to watch. According to Bloomberg data, more than 1.19 billion doses of the vaccines have been administered across 175 countries, representing the largest vaccination campaign in history. In the US 248 million doses have been given so far with a recent run rate of about 2.19 million doses per day.

Wall Street analysts are seeing light at the end of the tunnel. JP Morgan recently reiterated their call for a value play: "We believe this move is likely to accelerate as we move into late spring and the summer amid the reopening of the economy, with the primary beneficiary being value and cyclical stocks. Importantly, we do not believe these developments are priced in, and believe the reopening and reflation trade will resume with a move that will be bigger than we saw early this year."

In the equity market, cyclical stocks have been reacting much better to earnings news than their growth counterparts. Last month Netflix, often seen as the poster child for the “stay at home” growth theme, reported a challenging quarter which sent the stock tumbling ten per cent on the day. Last year’s pandemic-induced subscriber growth slowed faster than expected as people previously stuck at home began venturing out. On their conference call, Netflix announce their video-streaming service added four million more worldwide subscribers from January through March, its smallest Q1 gain in four years.

By comparison, banking and financial services bell weather, JP Morgan has outperformed the market by over 500 basis points since reporting a 49.3 per cent upside earnings surprise on April 14. Bank stocks benefit from both economic growth and higher interest rates, which have been climbing due to the improved economic outlook.

Although our base case is for a gradual reopening, there will likely a few bumps in the road. For example, last week’s payroll report highlighted some of the challenges in getting the world back to work. For the month of April, US non-farm payrolls increased by a mere 266,000, just a fraction of the consensus estimates for up to one million new jobs. On top of the weak headline number, revisions to earlier months lowered employment in February and March by a combined 78,000 more than previously reported.

While more vaccinations and a broader economic opening is bringing workers back into the labour market, enhanced unemployment benefits are also discouraging some of them from returning. Furthermore, a record low drop in wages last month was driven by additional workers being added in low paying industries.

April’s jobs report, however, could fall into the “bad news is good news category” by dismissing some of the recent tapering talk. Investors generally fear a reduction of central bank bond purchases or an increase in interest rates which could derail progress in the both the value and cyclical spheres of the market.

Going forward, investors should strive to stay well diversified. After the decade long run up in growth stocks led by the so-called FAANG’s – an acronym for mega cap growth stocks such as Netflix and Amazon – these positions have likely have become a significant portion of many portfolios. But it may not be too late for some adjustments.

That said, we are continuing to see important growth themes which are likely play out over the coming years. Expect innovative technologies applied in financial services, retail, manufacturing and healthcare to continue disrupting existing business models. Indeed, many value stocks are cheap for a reason and may become even cheaper if they are unable to adapt in a rapidly changing world.

By some estimates, the pandemic has pulled forward three or more years of innovation as technology has become our fallback position. Therefore, a well-designed growth stock strategy should continue to have an important place in most accounts. Just be prepared for greater volatility in technology heavy indices such as the Nasdaq.

On the value/reopening side of equation, investors should be aware that some of the reopening theme has been already been factored into current prices. For example, we see many restaurant, physical retail and hotel stocks currently trading at or above their pre pandemic levels of early last year. For these stocks to work, everything must go perfectly on the reopening front and investors must assume a travel and mobility scenario even better than we experienced prior to Covid-19.

Bryan Dooley, CFA is Head of Portfolio Management at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.

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Published May 18, 2021 at 8:00 am (Updated May 13, 2021 at 12:26 pm)

How to play the great reopening

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