U.S. Equities Are Likely to Be Range-Bound

Market Outlook: Despite Trade Wars--and Real Wars--U.S. Equities Are Likely to Be Range-Bound

By Michael LaBella, Head of Global Equity Strategy at QS Investors

Facing uncertain markets, with potential volatility shocks, what should U.S. equity investors do?

Investors should identify value stock opportunities with lower volatility. We suggest U.S. stocks with a focus on high dividends and lower price-to-earnings ratios, in addition to lower volatility. 

These dividend paying companies trading at a discount to the broader market have exposure to the value trade in addition to offering a defensive tilt. As such, they are less vulnerable to a late cycle correction or negative market shock. 

Representative examples of companies outside traditionally defensive sectors such as utilities include:

• Industrials – United Parcel Service (NYSE: UPS, 3% dividend yield)

• Consumer Discretionary – Carnival Cruises (NYSE: CCL, 3.96% dividend yield)

• Health Care – Pfizer (NYSE: PFE, 3.85% dividend yield)

The U.S. Federal Reserve (Fed), as expected, cut interest rates an additional 25 basis points on September 18 as the longer-term outlook has softened since July. Additionally, the Institute for Supply Management Index (ISM), a key manufacturing indicator, has moved into contraction for the first time since 2016. While the U.S. economy remains supportive, concerns surrounding escalating trade tensions and slowing economies abroad loom. 

As a result, U.S. stocks are likely to remain range-bound, and uncertainty will continue to be a major concern for investors.

Yet more aggressive Fed forward policy guidance is not expected. Despite the rate cut this week, the Fed is unlikely to proclaim the start of a more aggressive easing cycle, given healthy economic conditions outside the manufacturing sector and the robustness of the labor market. 

Value is back: For more than a decade, U.S. value stocks have underperformed U.S. growth and momentum stocks (by over 100% percent since the March 2009 lows).

The historic divergence between value and momentum came crashing down last week after momentum stocks realized their biggest one-day decline in decades. This reversal was likely technical in nature, since stocks with the highest short interest significantly outperformed those with the least short interest as investors increasingly covered positions in more crowded securities.

With technology and (more recently) low volatility stocks trading at such high valuation multiples, investors may finally be paying attention to price. Thus, we have seen more cyclical energy and financial companies are rebounding strongly this month. 

Despite rising global uncertainty and the softening of economic data around the edges, the market continues to rally, albeit with volatile shocks driven by trade wars and global conflict.

News headlines have followed a familiar cycle of positive posturing before ultimately disappointing the market prior to major trade meetings. Turbulence around trade is not transitory, dependent upon resolution of a specific agreement, but a new structural reality from the global populist shift. It will begin to weigh more negatively on sentiment and the manufacturing sector broadly.

Potential for Middle East conflict grew this past week. Saudi oil facilities were purportedly attacked by Iranian-backed rebels from Yemen. The resulting damage led to the largest one-day move in oil prices in over 25 years, a glimpse of what a larger conflict in the region could produce. With countries around the world realizing a synchronized slowdown, an oil shock would add greatly to global economic fragility. 

While the rotation into value is long over-due, its resurgence is a little inopportune. Given value’s cyclical exposure, via financials and energy, it may have heightened sensitivity to trade war volatility. 

At the same time, investors have to be careful buying purely lower volatility stocks at any valuation. Given the current momentum exposure embedded in many low volatility stocks, this trade may be prone to sharp reversals. We saw this last week during the sharp value-momentum rotation with the iShares Edge MSCI Min Vol USA ETF (BATS: USMV), which is up nearly 23 percent year to date but has been riding a bumpier road than expected.

Mike LaBella is a Portfolio manager at QS Investors, a subsidiary of Legg Mason. His opinions are not are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice.

Michael LaBella

Head of Global Equity Strategy,
QS Investors

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