The Thrill of Victory Meets the Agony of Defeat

By David Nelson, CFA
Trade and rising interest rates top the list of investor concerns as we kick off the earnings season. Banks take center stage Friday as JPMorgan (JPM), Citigroup (C ) and Wells Fargo (WFC) all report. Last week-long rates breaking to the highest levels since 2011 set the stage for a marked sell off in global equities. Large Cap U.S. held up best with the S&P falling just under 1%. Small caps gave up the most ground falling 3.80% in a miserable start for Q4. Across the pond, Europe still in an economic slump added to year to date losses but the hands down loser hast to be Asia with average losses close to 5% on the week.

China PRC Destroyer and the U.S.S. Decatur nearly collide
China US Ships Nearly Collide

China markets were spared given a week-long holiday but certainly not absent from the news cycle. Early in the week US and China Warships nearly collided in the South China Sea sparking a diplomatic scramble from Washington to Beijing.  A Pentagon spokesperson said; following a series of aggressive maneuvers the Chinese ship came within 45 yards of the U.S.S. Decatur. China’s claim to the Spratly Islands is disputed by Vietnam, the Philippines, Malaysia and Taiwan.
Also, late this weekend China’s central bank announced they were slashing reserve requirements to lower financing costs in an effort to spur growth. It looks like both sides are digging in for a protracted stand off on trade. China appears committed to defending the theft of intellectual property unwilling to give in on a point of national security not just for the United States but for any industrialized nation doing business with the mainland. White House Director of the National Economic Council Larry Kudlow said that talks are ongoing and substantive. However, he also said no trade deal with China is imminent.
Never the less the move by their central bank will inject about 750 Billion yuan or $102 Billion US into the system. By cutting the reserve requirement to 13.5% from 15.5% they hope to boost confidence. To do this, plans to reduce debt obviously take a back seat. It’s still important to put this in perspective given our combined economies of well over $30 Trillion.

US 10Y vs 2011

Meanwhile, back here at home rising rates have become the number one concern for investors maybe even outpacing trade. Look, make no mistake, as rates rise they eventually become a competing asset class. However, I still stand by my call that the terminal rate will be much lower than previous cycles. Inflation stands just above the Fed’s target of 2% and as long as expectations continue to hover in that range the Fed can move at a measured pace.

Growth vs Value vs S&P 500 10 Years

Maybe more important than the overall market reaction is what’s taking place underneath the surface. Growth (IVW) was down (-2.31%) last week while Value (IVE) was just about flat down 7 basis points. Of course, over a longer time frame Value hasn’t been much of a challenge to growth stocks like Amazon (AMZN) Facebook (FB) and Alphabet (GOOGL). One look at a relative performance chart over the last 5 years shows growth the hands down winner but as you can see there are periods of time where value kicks into gear. In the past decade those periods have been fleeting and each time I’ve written a post about how this could be a change of leadership and of course each time that call has been wrong.

Value vs Growth vs S&P 500 2000-2007

2014 on the heels of a biotech selloff growth stocks were hit hard and of course just after the 2016 election growth took a back seat to value following a Trump victory. Banks and industrials led the charge and last week had a similar backdrop. Rising rates are a new dynamic as the cost of capital goes up. It’s hard not to notice that given a very strong economy we’re seeing top line growth in several boring sectors and industries. Industrials, Consumer Discretionary and even Financials have top line growth today at multiples far below some of our growth favorites.
Of course, a week does not a trend change make but once again growth investors are being forced to make a gut check. For the last 10 years Growth and Momentum investors have enjoyed the Thrill of Victory while their Value brothers and sisters have endured the Agony of Defeat. Long term growth and value cycles can last years and the current one is no different. However, reversion to the mean is a pretty powerful dynamic that often has the last laugh. It’s been a long time but the last cycle where Value meaningfully outperformed Growth was following the burst with the outperformance lasting over 8 years.

Earnings season is dead ahead and will likely set the stage for the rest of the year. Expectations are high so there isn’t a lot of room for disappointment. Focus on top line performance for sustainability. There’s a lot you can do to smooth out earnings. Short of M&A revenue is usually the best metric to measure growth. Either you have it or you don’t.