BUG - Not Too Late To Ride The Bull Market But Look To Value For Safety

2023-07-17 23:00:00 ET

Summary

• The bullish momentum of U.S. equity markets has surprised many, with hedge funds rushing to unwind bearish positions and optimism growing for a soft landing for the Federal Reserve's monetary policy.
• Analysts are wary of stretched valuations and the risk of a market correction, particularly with tech and AI stocks trading near all-time highs, leading to investor concerns.
• The article argues against short-term market timing, suggesting instead a rotational strategy that involves deliberate changes to the composition of an equity portfolio, focusing on value, growth, quality, and size factors.
• Such a strategy means that investors can stay fully invested in equities, while still being able to manage risks and improve returns.

The bullish momentum driving U.S. equity markets has taken almost everyone by surprise. Last week's soft inflation data and resilient Q2 bank earnings are beginning to fuel optimism that a soft landing is achievable, paving the way for the Federal Reserve to normalize monetary policy. Reports also indicate that many hedge funds have been caught off guard by the rally, and are rushing to unwind bearish positions in an attempt to play catch-up. Meanwhile, we are finally beginning to see more optimistic headlines across the financial media, which only demonstrates the industry's abysmal track record at market timing.

However, even the most bullish analysts are increasingly wary of valuations getting stretched and that the risk of an equity market correction could be on the cards. Indeed, prices of large-cap technology and artificial intelligence ((AI)) stocks, in particular, are already trading near all-time highs. In light of the spectacular outperformance of tech stocks, and the increasing risk of a potential pullback that threatens to erase some of these gains, it is understandable that many investors are getting worried.

Should investors take profit and prepare for a pullback that may or may not materialize? What if the equity market continues to rally on the back of an improving earnings outlook? And what if we are only in the early stages of a multi-year bull market?

Regular readers of our research would know that we are stubbornly skeptical of short-term market timing. Not only do we see scant evidence of replicable success in short-term market timing strategies, but we also believe that such strategies are absolutely unnecessary for beating the market long term.

There Is No Point In Trying To Make Sense Of Prices Short Term

Short-term market timing is simple to understand, and perhaps that is why inexperienced investors are naturally attracted to it. Market timing can be as simple as dumping equities following a huge rally and sitting in cash (or other safer assets) in the hope of buying them back later at a discount. It makes perfect sense, except when one realizes that the financial markets have a tendency of foiling simple plans.

The reality is that no one really knows how far equity prices can run ahead of fundamentals before they eventually reverse. No one really knows if a stock with a deemed intrinsic value of $100 will trade at $150, $300, or even $600 within a given short period of time.

So long there are enough buyers and sellers who are willing to transact at ridiculous prices for a stock, then the stock price can be as ridiculous as those buyers and sellers will allow.

In the short term, stock market prices do not have to comply with any logic. And it should follow that attempts to time short-term movements in prices using some simple technique or logic would be inherently flawed.

Market timing necessarily involves solving the complex problem of figuring out where prices will be in the near future. Although it makes logical sense that stock prices should eventually reflect value, this value will always be a moving target and can grow or shrink over time due to underlying economics.

In the long term, we can at least make reasonable assumptions about the growth trajectory of a company and carefully account for future cashflows. We can then discount those cashflows to arrive at the present value for a stock. This is also known as the discounted cash flow method for valuing an asset. We can expect prices to temporarily stray away from intrinsic value, but prices should eventually converge towards intrinsic value over time. Otherwise, investors may be under-compensated for paying too much for a stock or over-compensated for buying at a discount. If investors are rational and would compete to sell at a premium and buy at a discount, prices should adjust over time to reflect fair value.

In the short term, however, it is a different story. Stock prices may potentially be driven by almost anything that affects investor sentiment. Thus, just knowing that a stock is overvalued doesn't help because no one knows how long it will take for prices to revert to intrinsic value. It is also almost impossible to tell how sentiment will swing in the short term depending on the constant flow of news.

Traders have invented various technical tools to help them identify and take advantage of short-term market swings. However, almost every technical indicator is either designed to capture a single factor (volume, standard deviation, momentum, etc.) that could help predict price movements or is designed as a blunt tool that tries to capture changes in overall market sentiment. Such indicators have often produced mixed results in short-term trading. Some indicators can even be interpreted differently, depending on the user.

Beating The Market Without Having To Time It

We hope that we have presented a reasonable case against market timing. Perhaps there is an easier way to beat the market without having to constantly make "risk-on-risk-off" decisions on a weekly basis. Perhaps we can stay fully invested in equities and still have a chance at outperforming the market over time.

One way to do that would be to adopt a rotational strategy, by making deliberate changes to the composition of the equity portion of one's portfolio without directly reducing allocation to the asset class. There are many ways to rotate equity exposure. For example, one can consider switching out expensive stocks for cheaper ones (value), or stocks with high and stable profitability (quality). This is also commonly known as factor investing . Many factors have been identified and heavily researched over the years and some factors have shown to be persistent across different markets and asset classes. Some of these factors include value, growth, size, momentum, quality, yield, low volatility, and liquidity.

One of the many advantages of adopting a rotational strategy is that an investor is able to stay fully invested during a bull market. By rotating between factors that are more likely to outperform from time to time, one can stay fully invested in equities without the risk of missing a bull market, and still be able to manage risk and improve returns.

At Stratos Capital Partners, we limit our selection to just 4 of the factors listed above and we rank our preference in the following order: Value, Growth, Quality, and Size.

One of the easiest ways to categorize stocks based on these factors is to consider groups of stocks group by industry. And based on the current market environment, the first logical step will be to reduce exposure to expensive big-tech and AI-related stocks that have performed exceptionally well and are now trading at valuations that are becoming increasingly difficult to justify. Other expensive stocks in our opinion would include aerospace and defense stocks. Prices for these companies are priced for perfection and appear to have fully reflected the prospects of an extended Russia-Ukraine war as well as growing tensions in the Taiwan Strait. The rebound in global tourism has also lifted valuations for some of the aerospace stocks that also manufacture passenger aircraft.

Next, would be to select factors that we think will outperform the market going forward. This is a fairly simple task. Because the recent equity rally has been overwhelmingly driven by tech stocks, there are many sectors that could potentially catch up. Hence, investors today are not restricted to industries with lower return potential such as utilities and other defensive sectors.

Valuations On Homebuilders, Biotech, and Cybersecurity, Are Still Attractive

For most value investors, failing to catch the bull market back in October 2022 would have been a critical mistake that could severely undermine the overall performance of a portfolio. Fortunately, there are many non-tech sectors that are still trading at a heavy discount to their respective peak in 2021. Thus it is not too late for investors who have failed to catch the bull market to start playing catch-up. This also presents an opportunity for investors who are looking to rotate out of tech stocks.

We initiated our bullish view on homebuilder stocks ( XHB ) in October 2022 and we continue to maintain a "Buy" rating on the sector. Despite the strong gains year-to-date, XHB is fairly valued at a reasonable forward P/E of 14.6x. D.R. Horton ( DHI ), which is our favorite pick among homebuilders, has gained by a whopping 80% since we initiated our "Strong Buy" rating on the stock. Despite the strong gains, we still see further upside potential in DHI given that the stock is still trading at an undemanding forward P/E of 11.5x.

Interestingly, biotechnology stocks ( XBI ) have lagged behind technology stocks and have hardly participated in the bull market rally. XBI continues to hover near the bear market lows and trades at a historically low forward P/E of just 17.9x. Given the long-term growth potential of biotechnology stocks, we view this sector as one of the most attractive right now.

Finally, we still see immense potential for sustained long-term growth in cybersecurity stocks ( BUG ). However, because many companies in this rapidly growing sector are still scaling up aggressively and are barely profitable, P/E ratios may not be a good measure of value. Admittedly, valuing this sector is a challenging task. But given that we are seeing resilient revenue growth of 20% to 30% across leading cybersecurity companies, we believe that the sector deserves to outperform the broader technology sector.

In Conclusion

We recommend adopting a rotational strategy in the current market environment, which will allow investors to stay fully invested during a bull market. By rotating between factors that are more likely to outperform from time to time, one can stay fully invested in equities without the risk of missing a bull market, and still be able to manage risk and improve returns.

We see attractive opportunities to rotate out of big-tech and AI-related stocks and to invest in homebuilders, biotechnology, and cybersecurity stocks, which we think are likely to outperform in the medium to long term.

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