Happy 9th Anniversary Bull Market

Benjamin M. Lavine, CFA, CAIA

3D rendering of number nine made of gold with reflection isolated on white background.

This is the third bull market anniversary piece published by 3D since my arrival at the firm in 3Q2015.  The prior two can be found here and here.  Hopefully, this won’t be the last anniversary piece we publish as this current bull market keeps pushing along despite its age and high market valuations.  In the prior two anniversary pieces, we sounded cautionary but bullish tones, that despite high valuations (at the time), equity markets could continue their advance alongside earnings growth (Figure 1). 

Figure 1 – It’s Been a Strong 10-Year Run for the S&P 500 Index

Source: Bloomberg

In Happy 8th Anniversary Bull Market, we wrote:

“Earnings anchor equity markets, and apart from the crazy late 1990s Internet Bubble, rarely do equities disconnect from the earnings picture.  If the earnings picture were to falter, either because the current economic cycle finally gives way to recession or proposed fiscal stimulus/regulatory reform do not meet current expectations, then equities may succumb to gravity as earnings would no longer provide substantive support for further advances.”

Despite a healthy 20.2% return over the past year (ending 3/9/2018) for the S&P 500 Index, not much has changed with respect to equity or fixed income risk premia.  Prior to the early February sell-off, the S&P 500 was trading at ~18.3x estimated earnings per share over the next 12 months (NTM), which was slightly above 18.3x NTM EPS on the 8th anniversary of the bull market last March (as of the time of this writing, the S&P trades at 17.8 NTM EPS).  Similarly, U.S. high yield spreads above U.S. Treasuries, as measured by the Bloomberg Barclays High Yield Index, are unchanged from the prior year (~3.3% spread). 

What occurred over the trailing year was an improvement in corporate fundamentals with year-over-year revenue increasing 7.7%.  Hence, both U.S. equities and high yield fixed income posted strong year-over-year returns of 20.2% and 5.2%, respectively, with little change in market valuations.  We’ve written several times that further market advances will rely on fundamentals, rather than expanded valuations, and this past year affirmed that. 

Admittedly, we’ve been more bullish on small cap and value risk premia (as opposed to growth, quality, and momentum), but near-term sentiment has favored large cap growth, especially technology stocks. There have been sporadic moments when small cap and value have outperformed large cap technology (as proxied by Nasdaq 100), but this has been a bull market for large cap growth investors (Figure 2). 

Figure 2 – It’s Been (Mostly) About Large Cap Technology

And why is that?  Don’t small cap and value generally perform well in a rising-tide-lifts-all-boats type of market?  Well that hasn’t necessarily been the case this time around; this cycle has been characterized where growth and profitability are not enjoyed broadly across U.S. companies but rather isolated to narrower segments, such as technology and health care companies. 

Valuations Matter…But Must Be Viewed Within the Context of Profitability

Figure 3 displays the price-to-book and forecasted return-on-equity (next 12 months) spreads between the S&P 600 Value Index (small cap value proxy) versus the Nasdaq 100 (growth proxy as this has become the popular positioning among retail and institutional investors). 

Figure 3 – Value’s Profitability Cannot Keep Up with Growth’s

Small cap value stocks trade at a structural discount to their large cap growth premium, but this discount is time varying.  Small cap value stocks are structurally less profitable and capital efficient versus large cap growth as measured by return-on-equity, but this is also time varying.  There are certain periods where these ‘gaps’ are narrower and other times when they are wider, but these structural discounts affirm rational capital market pricing and why small cap and value stocks are treated as ‘riskier’ stocks versus large cap and growth. 

But has large growth investing gotten too popular and small cap value too unloved?  Clearly the widening valuation gap between Nasdaq 100 and Small Cap Value stocks can be largely explained by the widening profitability gap that has emerged between the two groups.  It appears Trump-o-nomics have provided more benefits to global large cap tech companies rather than more domestic-oriented, cyclical small cap companies (a weakening U.S. dollar has also generally favored the former over the latter).  Yet, one can argue that the valuation and profitability spreads have hit extreme points (dotted black circle) relative to their history going back to 2006:

  1. The valuation gap has widened to extreme levels as the price/book valuation on Nasdaq 100 has reached a cycle high, which can be explained by…
  2. …the record profitability of Nasdaq 100 stocks forecasted by Wall Street analysts.  The profitability gap between small value and large cap tech only recently narrowed as the profitability improved for small cap value from their extremely low levels. 

Figure 4 displays the rolling 1-year return difference between the S&P 600 Value versus Nasdaq 100 spanning the current bull market.  For most of the periods observed, Nasdaq 100 has outperformed S&P 600 Value as the superior profitability profile of large cap tech has trumped the cheaper valuations of small cap value.  As with valuation and profitability, the gap in relative performance has reached a local extreme in favor of large cap tech over small cap value. 

Figure 4 – U.S. Large Cap Tech Has Outperformed Small Value Over the Majority of Rolling 1-Year Periods

February 2014 represents the prior period where this extreme in relative valuation, profitability, and performance was last observed, and, in hindsight, mean reversion occurred over the subsequent period with small cap value making up some relative performance versus large cap tech. 

At the 9th anniversary of this bull market, we seem to have reached a similar level of extreme sentiment favoring large cap growth versus small cap value.  Investors betting on the former versus the latter are betting on cycle high levels of profitability for large cap growth tech being sustained in the face of rising cost pressures and regulatory scrutiny while betting against the improving profitability of small cap value.

Valuation alone is not a great timing tool when taking tactical positions without taking into context the fundamental and technical backdrop driving the valuation gap.  However, we may have reached a point where too many investors have flocked to one side of the boat, increasing the risk of a capsized trade. 

The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of March 10, 2018, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing or visiting 3D’s website

By: Benjamin Lavine