Style: Growth / Value

Small cap stocks were hit harder than large caps in the weeks leading up to the election, as investors shed riskier assets. Fuel for this selling may persist in the near term, based on the readings from the latest NFIB survey of the small business sector. The survey was lackluster, and showed that small company margins may come under renewed pressure, based on the jump in the planned labor compensation survey. Nevertheless, we recommend riding out any additional volatility. Large companies are also contending with rising wage costs, and our relative profit margin proxy continues to grind higher, in favor of small caps. Given our domestic vs. global emphasis, the window for small cap outperformance remains open. Size Cycle Update Size Cycle Update

It's hard to make a case for attractive returns from any asset class over the next year. We dial down risk a bit but ending our overweight on junk bonds. Investors should pick up yield where they can but without taking excessive risk.

Our <i>Cyclical Indicator Update</i> reveals that a defensive portfolio strategy remains the best bet to navigate the crosscurrents of stagnant profit/economic growth yet abundant global liquidity.

Since downshifting from favoring growth over value to a neutral style bias at the beginning of this year, the growth/value (G/V) ratio has corrected sharply. While this recommendation shift was timely, at issue is whether a major cyclical trend change is underway, or if a resumption of the advance lies ahead, and/or another style switch is appropriate. Before making any decisions, it is critical to understand the driving forces behind the last few months' price action. Growth indexes have a hefty non-cyclical element compared with value benchmarks. In addition, growth is tech-heavy while value is dominated by financials. Thus, the rebound in cyclical sectors alongside the gentle depreciation in the U.S. dollar and oil price recovery provided a good reason for value-oriented stocks to rebound. However, that rally has not been accompanied by any real improvement in the global business cycle. Now that U.S. employment is starting to soften, concerns about the health of the expansion may broaden. Growth indices have a strong track record of outperformance when economic expectations are weak, as proxied by declining global government bond yields (shown inverted, top panel). The surge in the S&P dividend aristocrats index is also consistent with a safety bid rather than a return to 'risk on'. For these and other reasons outlined in yesterday's Weekly Report, we recommend returning to a growth vs. value bias. Return To A Growth Over Value Bias Return To A Growth Over Value Bias

Last week's soft employment report reinforced our defensive vs. cyclical portfolio bias, as firms appear to be slowing hiring in response to the broad-based profit squeeze. That is a plus for non-cyclical sectors, as defensive sector profits have steadily outperformed in the last two years, supporting share price outperformance. The opposite is true for cyclical sectors, notwithstanding the bounce earlier this year. At some point, the tide will turn in favor of cyclical sectors, but a number of factors argue against making such a leap of faith at the moment, please see the next Insight. bca.uses_in_2016_06_07_001_c1 bca.uses_in_2016_06_07_001_c1

Economic disappointment will become the key theme in the second half of the year, driving a return to non-cyclical market leadership and a recovery in the growth vs. value ratio.

A number of factors triggered our downshift from a growth over value bent to a neutral style bias in late-January. Value has outperformed growth in 80% of broad equity bear markets since 1960, and in more than half of economic recessions. While neither outcome is assured, they have become much higher probabilities as credit conditions have tightened. Sector weightings also played a role, as growth indexes have nearly quadruple the tech sector exposure as value benchmarks, and more than double the consumer discretionary exposure. We are bearish on both sectors. The incentive to bet on growth stock outperformance from current premium valuation levels continues to diminish. Overall long-term S&P 500 earnings growth expectations have been pared back aggressively of late. Reduced confidence in the secular profit outlook is a headwind for overall valuations, but particularly for growth vs. value stocks. The chart shows that momentum in the G/V ratio closely follows trends in 5-year earnings growth expectations, and the current message is that the price ratio has hit a ceiling. Growth Vs. Value Has Hit A Ceiling Growth Vs. Value Has Hit A Ceiling

Growth stocks have trounced value indexes over the last few years. The bulk of our style Indicators signal that macro conditions are still tilted in favor of growth. As a reminder, growth indexes almost always move to a premium when economic growth declines, as is currently the case. Nonetheless, we are losing conviction in the ability of growth stocks to sustainably outperform from current levels, despite our downbeat view of global economic growth prospects. Comparing the genetic makeup of the growth and value benchmarks with our current sector positioning suggests extrapolating recent gains is becoming higher risk. Growth indexes have nearly quadruple the tech exposure of value indexes, at the 32% vs. 8%. Consumer discretionary, another underweight, represents 18% of growth indexes vs. 7% of value indexes. That is a 35% weighting difference from two sectors. Meanwhile, the defensive telecom services and utilities sectors are 10% of value exposure, but only 3% of growth benchmarks. Importantly, growth stocks have a checkered past once equity bear markets and/or recessions set in. Since 1960, value has outperformed in 80% of bear markets. Value has also outperformed in 5 out of the 8 recessions since that time. While neither recession nor bear market is guaranteed at the moment, both are becoming higher probabilities. Adding it all up, we are moving to neutral in our growth vs. value bias after a 10% gain. Please see yesterday's Weekly Report for more details. The Easy Money Has Been Made In The Style Bias: Time To Shift The Easy Money Has Been Made In The Style Bias: Time To Shift

An oversold bounce may be getting underway, but without a policy assist, it would be a rally to sell. Go to neutral in the growth vs. value trade and beware sub-surface weakness in the consumer discretionary sector.

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