Expectations of economic growth push up stock valuations in advance but often not so much when this growth actually occurs.
Remember how the stock market plummeted in March 2020 at the onset of the pandemic and then turned sharply upward to become a resuscitated, robust bull market?
This apparent disconnection with the COVID-19-crippled economy gave many investors a backward feeling, much like when the bull market that began in March 2009 belied the most severe recession since the Great Depression.
If you’re expecting a surging market to result from today’s recovering economy, prepare to have that backward feeling again. Sure, the economy is recovering apace, but to a considerable extent, gains from this recovery are already priced in because the market is forward looking: Expectations of economic growth push up stock valuations in advance but often not so much when this growth actually occurs.
Some stocks will register gains from economic recovery for months to come but not to the magnitude expected by investors who are overly zealous believers in the so-called recovery trade.
Over the past 10 years, starting with the economy’s slow climb out of the Great Recession, returns of the Dow Jones Industrial Average (DJIA) have been several percentage points above its 23-year average of 8.92%. The index’s 50-year average is 10.9%, and for the past decade, it has delivered about three percentage points above that. That’s huge.
The next decade could easily be two to three points below the 50-year average, but still decent, compared with the many leaner market periods that figure into it. For domestic equities over the next decade, the analysis firm Strategas is projecting an average annual return of 7%.
As many investors experience that backward feeling in the coming months, the market will continue its now-nascent evolution from a remarkably abnormal period. This started with a sometimes-interrupted 11-year bull market, gave way to the black swan event of the pandemic (a sudden trough and then ethereal ascent) and then took on the current personality of extremely high volatility. The economy can’t grow briskly, nor can a bull sprint, indefinitely — and the market may be reflecting that now.
Over the next one to three years, the market will become more normal; that is, it will deliver returns more characteristic of historical averages. This return to normalcy won’t be sluggish, just a slower leg of what I see as the DJIA’sjourney to 50,000 by the year 2027.
The approaching slower period will likely be characterized by lower performance by growth stocks (especially big tech growth) and improving performance from older, established companies with a long history of stable performance and reliable dividends, known as dividend aristocrats. Names of these companies can be found in various exchange-traded funds (ETFs) based on this concept, including NOBL. Many of these stocks are currently exhibiting value stock characteristics. Although many growth companies are young firms that reinvest profits in their enterprises, mature companies like the aristocrats use real profits to pay dividends to get and keep investors.
There’s evidence that the growth/value seesaw is already starting to tip the other way. Over the past two years, growth stocks have trounced the large, venerable dividend aristocrats, returning 72% (as represented in the NASDAQ 100 ETF QQQ) compared with 34% for NOBL. But in the past three months or so, the tide has turned: NOBL has gained 14% while the QQQ has lost 7%. And Vanguard, which literally wrote the book on value stocks, projects value beating growth by 5% to 7% over the next decade. So investors getting a head start on normalcy could fund the purchase of value-esque dividend stocks with money from the sale of growth stocks before they decline further.
This would help investors position not only for the stable earnings that the aristocrats offer, but also for their qualified dividends, which are taxed at a lower rate (15% for many currently) than capital gains. This combination of low taxes, dividend yield and stability makes aristocrats like 3M and Caterpillar Inc. a viable alternative to bonds now that bond yields are virtually nonexistent and bonds offer less risk protection because of their increasing correlation with stocks.
This is not to say that some growth stocks won’t do well over the next few years, but if the current trend continues, it will be increasingly difficult to pick winners in this category. Meanwhile, many investors’ penchant for opportunistically buying growth companies that are all potential and no earnings will likely fall out of fashion, much to the benefit of companies that consistently post positive earnings numbers.
However, it’s important not to paint all tech companies with a growth brush. Many established, large tech companies with real earnings in fields like semiconductors will likely remain viable. Amid the current semiconductor shortage (which curiously stemmed from anticipating less demand during the pandemic rather than what turned out to be more), companies like Nvidia and others in the ETF SMH are trying to crank out chips as fast as Frito-Lay to meet near-ubiquitous demand for products including digital toasters, phones, autonomous cars, you know it.
Yet the performance of many tech companies in the growth category is ebbing, and this will probably continue, causing money to flow elsewhere. Eventually, much of this money will probably find its way to mature companies such as the dividend aristocrats.
This scenario suggests a barbell asset-allocation strategy of sorts. On one end of the bar, investors could holdsubstantial amounts of long-term dividend payers — dividend aristocrats and real estate investment trusts (or, REITs) — with dividends comprising one-third to one-half of expected returns.
Then, on the other end of the bar, investors could allocate a smaller portion to growth stocks. These stocks might include a judicious selection of growth tech companies likely to do well from their role in the digital revolution. But investors should probably avoid huge growth tech companies that shot up and stayed strong through the pandemic and then faded — for example, Netflix, Amazon and Tesla — and smaller companies likely to struggle to maintain their lockdown-period growth. Many of these have stretched or negative price-earnings ratio, e.g., Zoom and Peloton.
This lesser allocation to growth stocks would ideally include shares of companies from various sectors that are becoming performance outliers. I say “are becoming” because once they’ve become established performers, prices may be too high. Stocks in this category tend to have good fundamentals — rising sales and earnings growth and low debt — and, perhaps most important, rapidly rising acquisition by institutions, as indicated by an increasing percentage of institutional ownership relative to individual ownership. These data can be found on your brokerage’s website.
Setting up this lopsided barbell allocation shouldn’t require a lot of heavy lifting, but it will require a little research and planning. Yet there’s time for this because, although the transition to normalcy has already started, it will be gradual.
So when you get that backward feeling, consider what the market conditions causing it might portend for the durability of your present equity portfolio.
Dave S. Gilreath, a certified financial planner, is a 40-year veteran of the financial services industry. He established Sheaff Brock Investment Advisors LLC, a portfolio management company based in Indianapolis, with partner Ron Brock in 2001. The firm manages more than
$1 billion in assets nationwide.