In Brief
- Equity markets have continued to recover impressively from the collapse last spring, with the success of vaccines further underwriting the prospects for a very robust year for corporate profits.
- Valuations are now much higher and approaching historical records for the fastest-growing companies. Speculative activity is on the rise as well. But our investors take comfort from powerful earnings growth and the favorable comparisons with exceptionally low bond yields. Our overall return expectations are still positive but more subdued these days.
- Within the markets, we recommend a balanced approach at a time when many investors appear still heavily focused on the secular technology-driven winners that have proved such successful investments over the past decade. As the recovery unfolds, a broader range of companies should continue to participate.
Taking stock
The recovery from the pandemic-driven recession is well underway. Our research team sees an impressive 25% gain in global corporate profits this year, and with both monetary and fiscal policy working flat out and the vaccine rollout picking up pace, we are confident that these forecasts are realistic. Profits in the secular winning categories have continued to rise at a healthy rate throughout the crisis, and a vigorous rebound is already occurring in many cyclical industries.
But as we discussed at our Global Equity Investors Quarterly in late January, this recovery is already well priced into markets. That presents a challenge for investors. Even allowing for robust gains in profitability, equity market valuations are at the high end of past ranges. The S&P 500, for example, is trading at 22x forward earnings, a level that in the past has suggested very modest returns on a five-year view (although multiples say little about returns over shorter time periods). Our expected return for emerging markets has fallen to a 10-year low. Even unfashionable Europe doesn’t look especially cheap—outside the UK, where equities trade at their lowest relative valuations in 40 years.
Meanwhile, we see signs of speculative excess in several corners of the markets. Our quantitative research tells us that 2020 was the best year since 1999 for owning not just the fastest-growing companies but also those with no history of operating at a profit (EXHIBIT 1). The boom in special purpose acquisition vehicles (SPACs) and aggressive retail investor activity in the U.S. may be additional warning signs. And yet equities still look attractively valued compared with bonds. Overall, we expect modest but positive returns from equities, with profitability surging and low interest rates providing support. Valuation differences within the markets remain extremely wide, and our team continues to be upbeat about the prospects for stock selection.
2020 was a record year for stocks with high forecast sales growth but no track record of profitability
Source: FactSet, IBES, J.P. Morgan Asset Management. Charts show the active returns of the top-quintile portfolio relative to the equally weighted universe, gross of transaction costs, December 31, 1994–December 31, 2020. Portfolios are constructed in the Behavioural Finance global all-cap investible universe.
Spotlight on China and renewable energy
We discussed two long-term growth themes—China and renewable energy— at our latest quarterly.
China is leading the world’s recovery, and although the stock market has performed well, our team still finds plenty of long-term opportunities. Valuations look more or less reasonable to us. Retail investors are once again active market participants, yet margin balances remain low by past standards. While U.S. sanctions have hurt high end Chinese technology firms and briefly depressed some stock prices, the overall impact has been modest. We continue to favor investments in the long-term potential of industries with a strong secular tailwind. Examples include electric vehicles, health care and consumer brands.
Turning to renewable energy, the opportunity is clear. Renewable energy is a large and growing market driven by decarbonization and the electrification of energy. Demand is well supported globally by policymakers, customers and economies, and renewable energy is the cheapest form of new current generation almost everywhere. We can see electricity generation accounting for as much as 50% of total renewable energy in 30 years, up from a current level of 7%. But while the growth prospects are enticing, they are well understood by investors. The median stock in the renewable energy sector rose over 100% in the last year and now trades at more than 35x forward earnings. Interestingly, European companies have taken leadership roles in many instances, in stark contrast to the European experience in technology over the past two decades. This is another reason to stay invested in European equity.
We can still find attractive opportunities in residential solar, electricity grid infrastructure and battery technology, but patience will be required, given recent investor enthusiasm and high valuations (EXHIBIT 2).
Renewable energy’s enticing growth prospects are well understood by investors
EXHIBIT 2: POWER GENERATION SECTOR MIX
Source: BloombergNEF, IEA; data as of December 16, 2020.
Are growth stocks in a bubble? Certainly some high valuations, but still opportunities in “interrupted growth”
It is obvious that high valuations can be found in many growth stocks these days. After many years of tremendous returns (the S&P 500 technology sector has compounded a 20% gain for a decade, rising sixfold over the period), we are often asked if growth stocks are now in a bubble. We can indeed see some parallels with the market frenzy of 1999–2000, including growing excitement about companies in the “pre-profit” phase, heavy retail investor involvement and, of course, some very aggressive valuations. But we also observe notable differences between the two periods. Today, the underlying profitability of the leading companies remains exceptionally good, and also it seems that we are at the beginning rather than the end of an economic cycle. Still, we have reduced exposure to many of the most popular technology names in our growth portfolios—stocks that are now heavily weighted in industry benchmarks. We find better opportunities in more attractively valued, cyclical growth areas where major headwinds from the COVID-19 crisis are now turning into tailwinds, such as online brokerage and leisure travel, as well as several industrial companies.
We see good reasons to be optimistic about value stocks
It’s been a rough stretch for value investors. In our estimate, the style has been out of favor for 14 years, the longest if not the most severe period of underperformance that we can find in market history. Recent gains since the first positive results on vaccines in mid-November have barely improved that poor record, but our value investors see five reasons to believe that value stocks can deliver strong performance in 2021:
• Strong earnings growth has always benefited value investing, and we are forecasting strong earnings growth over the next two years: 25% for the MSCI World, 23% for the S&P 500 and 35% for the MSCI Emerging Markets. We haven’t seen corporate earnings growth like this for a decade, and the next two years of profits growth will act as a huge tailwind for lower priced companies.
• Extraordinary fiscal and monetary stimulus in much of the developed and emerging worlds will likely continue to fuel the earnings recovery.
• Even a modest rise in inflation should provide a tailwind for value stocks, given inflation links to the cost of equity and cost of money.
• Positioning looks favorable. Simply put, there are not many value investors left. Only 7% of global fund assets are managed in the value style, down from over 30% 15 years ago.
• Value stocks are a relative bargain. Valuation spreads between high and low valued companies are unusually wide—at the 99th percentile level on a global basis.
As ever, research and selectivity will be key to our value investing. We remain very reluctant to look for recoveries in the most troubled and indebted companies.
In sum, across markets and sectors, we see a wide range of opportunities and a few key risks to monitor—as captured in the word cloud below (EXHIBIT 3).
VIEWS FROM OUR GLOBAL EQUITY INVESTORS QUARTERLY, January 2021
EXHIBIT 3
A subset of survey results is shown for Global Equity Investors Quarterly participants, taken in January 2021. These responses are taken from a quarterly survey representing 37 CIOs and portfolio managers across global equities.
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