Are You Prepared for “The Great Rotation”?

W. Kirk Taylor, CFP ®

2021 was a year in which investors consistently climbed “A Wall of Worry” and looked past a long list of issues to worry about such as the January 6th Capitol Hill assault, rising inflation, supply chain disruptions and two new Covid-19 variants, to name a few. The S&P 500 [1] gained 26.9%, the Dow Jones Industrial Average (DJIA [2]) gained 18.7% and the Nasdaq Composite gained 21.4% in 2021. In fact, the S&P 500 notched 70 all-time new highs in 2021, a record not seen since 1995. There is no doubt that the ability to shrug of obvious risk factors is the hallmark of bull markets; that was certainly the case in 2021.

So far in 2022 however, the market has not been able to look past emerging risks, especially with regard to inflation and the prospect for higher interest rates as the Federal Reserve Board looks to taper its bond purchases and lift the Federal Funds rate multiple times over the balance of the year. Indeed, fears that the Federal Reserve Board is “behind the curve” is creating daily volatility that has not been seen since the COVID-19 induced sell-off in early 2020.  

The Dual Mandate

In our last Kirk Confident article, Winds of Change?, my colleague Dr. Mark Troutman laid out the case for persistently higher inflation over the coming quarters and pointed out that some inflationary inputs (notably labor wages) may be with us for longer than we’d like and is currently expected. Moreover, the Fed’s dual mandate of keeping inflation in check while maximizing employment is likely to be tested in a way that has not been tested in decades. With both the equity and fixed income markets trading at, or near all time highs, and P/E multiples well-above the long run median, the risk of a policy mistake by the Fed, is likely not inconsequential to investors. Consequently, we think this new investment landscape infers meaningful portfolio changes for the average investor with regard to risk management, asset allocation and security selection.

Value versus Growth

As the title of this article suggests, our view is that we are in the early stages of The Great Rotation. We believe that the economic backdrop in front of us, sets the stage for a multi-year rotation away from companies that trade at lofty price earnings (P/E) multiples a.k.a. growth companies and into low P/E multiple companies a.k.a. value. Growth, as an investment style, has outperformed value for the better part of the last decade and noticeably over the three and five year periods as shown in the chart below, so one has to ask if we’re not on the cusp of a large reversion to the mean, with regard to investment style.

According to Morningstar, the iShares S&P 500 Value (symbol: IVE) ETF currently trades at 16.7 times next year’s earnings, while the iShares S&P 500 Growth (symbol: IVW) ETF currently trades at nearly 21 times next year’s earnings. As you can see in the chart below, large cap growth and large cap value delivered nearly identical returns in 2021 but the strength in growth quickly reversed course as we flipped the calendar for the new year. In our view, the market has sent a clear signal that a changing of the guard is at hand. Although growth stocks are much cheaper than they were only a few months ago, this near term trend of value outperforming growth is likely to persist for quite some time.

We believe that the economic backdrop in front of us sets the stage for a multi-year a rotation away from companies that trade at lofty price earnings (P/E) multiples a.k.a. growth companies and into low P/E multiple companies a.k.a. value. In our view, the market has sent a clear signal that a changing of the guard is at hand.

Go Where the Hockey Puck is Going, Not Where it is

When a reporter asked famed NHL hockey player Wayne Gretsky why he was such great hockey player he responded by saying that he went to where the hockey puck was “going”, not where it “was”. The same is true for investors; the trick to staying “ahead” of the market on a “risk-adjusted basis” is to anticipate where the puck is going.

From the perspective of optimizing a portfolio, investors should follow these basic investment principles:

• overweight/underweight stocks and bonds given underlying economic conditions
  • overweight stocks when the economy is expanding and underweight bonds
  • overweight bonds when the economy is contracting and underweight stocks
• overweight/underweight S&P 500 sectors based on the current and near-term outlook for the business cycle
  • when the economy is expanding, sectors such as consumer discretionary as they tend to outperform the market on a relative basis
  • when the economy is contracting, sectors such as consumer staples tend to outperform the market on a relative basis

In short, we believe that the conditions have changed such that expansion will slow, and it calls for a shift to favor value over growth.

In closing, now is the time for investors to seriously scrutinize their portfolios and know quite clearly where they stand with respect to growth versus value. Additionally, investors who profited nicely by riding the growth wave over the past decade are likely woefully underinvested in value stocks and in sectors of the economy that tend to perform best in an inflationary environment coupled with rising interest rates. That’s only logical. Afterall, when was the last time boring companies like Chevron, Alcoa and Coca-Cola were making headline news?

One final point. We’re not saying that well-known growth names like Amazon, Apple, Google and Costco etc. should not be represented in a balanced portfolio. Rather we are saying that if these companies represent an outsized part of your portfolio, either directly or indirectly via mutual funds or ETFs, know exactly what your exposure is and have a strategy for rebalancing. While there’s little reason to fear a recession in the near-term, it’s clear that if the Fed cannot engineer a soft-landing once its rate hike campaign is underway, the risks will be to the downside for investors in the form of bear market.

As the saying goes, “bulls make money, bears make money, but pigs get slaughtered”……and now is not the time to be piggish!

Footnotes:

[1] What Is the S&P 500? How Does It Work?, Benjamin Curry December 8, 2021, https://www.forbes.com/advisor/investing/what-is-sp-500/

[2] Dow Jones Industrial Average: What Is the DJIA?, Benjamin Curry March 3, 2021, https://www.forbes.com/advisor/investing/what-is-djia/