Review the latest portfolio strategy commentary from Mike Gibbs, managing director of Equity Portfolio & Technical Strategy.
This week’s positive news on a potential COVID-19 vaccine has fueled a sharp rotation within the market as the relative beneficiaries of the stay-at-home environment gave way to the areas most impacted by the pandemic. For example, the underperforming industry groups year-to-date have gained 6.1% on average since last Friday, whereas all other areas are roughly flat (0.5%) on average since then. This rotation on vaccine optimism shining a “light at the end of the tunnel” is spurring questions around portfolio re-positioning toward the laggards.
Although this time the rotation may finally last, we recommend a more pragmatic approach to portfolio changes and prefer to build positions as the technical trends are sustained over time (particularly with the virus spreading rapidly right now). Our favored areas for portfolio rotation adjustments are the small caps, industrials, and materials, followed by the financials. Capital to increase exposure to these areas can come from select areas of Technology. Portfolio diversification is building importance once again, as the market becomes less dependent on a small segment of stocks that have dominated the stay-at-home environment. This not only creates more opportunity broadly across all areas of the market, we also view it as a positive for overall market strength.
Technically, the sharp S&P 500 up-move over the last 10 days (9.2%) is suggestive of above average returns over the intermediate term. After such sharp gains historically, it is normal to see some consolidation in the short term; however, moves of this magnitude are very often also followed by strong returns over the next 6-12 months. For example over the past 15 years, the S&P 500 has experienced a >7% initial move in 10 days only 20 times before this week. The average return over the next 6 and 12 months has been 14.3% and 20.2% respectively (with 88% and 94% positive rates). This compares favorably to 6 and 12 month returns in all periods of 5.3% and 10.8% respectively (with 76% and 82% positive rates).
Fundamentally, a very strong Q3 earnings season has continued the upward trend in S&P 500 earnings estimates. And while interest rates have moved marginally higher recently, the S&P 500 equity risk premium (S&P 500 earnings yield vs 10 year Treasury yield) is 3.0%. This remains historically elevated and supports our view that valuation multiples can remain lofty given exceptionally low interest rates. Since 1962 (following at least a 3% reading), the S&P 500 has seen positive returns over the next 3 years every time with an average annualized return above 8%. Headwinds remain (i.e. rapid virus spread, Senate control, size and timing of fiscal aid), but we would use pullbacks as buying opportunities for the longer term.
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