Manager Q&A - with Michael LaBella - QS Investors
How do you view the U.S. economy?
The U.S. economy continues to strengthen. We saw potentially mixed signals out of the first quarter with economic data, but all signs point to continued robust growth. Unemployment is at 48-year lows. We must go back to pre-1970 to see unemployment this low. In fact, there is talk about underemployment as an opportunity in the market, and market participants are monitoring wage inflation closely to see if that is the case.
We have had 31 consecutive months of job growth – the longest on record – with more than six million new jobs created during this period. Q2 GDP continues to track higher, into the 3.5 percent to 4 percent range. These positive results are making it more likely that the U.S. Federal Reserve will be on the lookout for a more aggressive dot plot, solidifying potentially four rate hikes this year.
Yet while economic returns have been broad-based, equity market returns have not?
Equity markets have been fairly narrowly driven. Market leadership started to narrow in 2017, when winners significantly outpaced losers. In 2018, we continue to see that, even more. The S&P 500 year-to-date is up over 4 percent, but there is significant dispersion among style and sector this year, even more than last year and the year before. Technology stocks (up 14 percent) and Consumer Discretionary (up over 12 percent) continue to lead the market rally. The laggards – particularly more defensive areas of the markets – are not even participating in the rally: Consumer Staples are down 10 percent and Telecoms down over 7 percent.
When we look at investment styles, we see similar story in the performance of growth over value: growth is up over 10 percent this year, and value is up only 33 basis points. This is the fourth largest underperformance of value by growth in the last 20 years. Last year was the second worst.
Last year, the Tech sector accounted for about 40 percent of the S&P 500’s total return. This year, it accounts for 70 percent. Last year, the top five stocks, mostly the FAANG1s, accumulated almost a quarter to the S&P 500’s return. This year, the same five stocks account for more than 50 percent of the return. We saw leadership at the top last year but broad-based growth through the second and third tier of sectors. We see a very sharp dichotomy between those in the cyclical-oriented sectors, particularly in Technology and Consumer Discretionary, versus everybody else.
What do you perceive as the greatest risks to continued economic expansion?
The IMF2 recently published a report raising awareness that this economic expansion is getting older. They pointed to the record piles of floating and leverage corporate debt, raising concerns on how corporate bonds will be impacted as interest rates continue to rise, particularly if rates rise faster than expected. We have started to see some of this play out in external debt issues for emerging markets, because of the strengthening U.S. dollar.
The election in Italy highlighted potential issues with the stability of the European financial system. The market was a bit shaken with the news, reminding us how fragile the system still is. Markets calmed down pretty quickly, but to put it in context, the new Italian coalition government is essentially analogous to the Bernie Sanders wing of the Democratic Party forming a coalition government with a Donald Trump wing of the Republican Party. There will be more fireworks.
How do you assess the volatility of the U.S. equity markets?
The market seems more attuned to risks this year than last year. We saw that in February with the market disturbance, but ultimately investors continue to exhibit a tendency for complacency. While the market has essentially acknowledged risk and volatility has returned, it has quieted down quickly.
When the market throw-down occurred back in February, there was a significant uptick in the both implied volatility: VIX touched 50 but also hovered around the long-term average of 15 to 20. Typically, when VIX hits over 40 or 50, we expect it will take one or two years for it to drop below 10. In fact, over the last 30 years, the fastest it had ever gone down from 50 to below 12 was about 227 days. This year, the VIX went from 50 to below 12 in under 85 days. That was a remarkably fast correction, but we do caution that the market is more prone to volatility than it was in 2017.
What do you think is interesting today in equity markets?
Narrowly-driven markets such as the ones we have been in since 2017 generate immense opportunities in those names that appear out-of-favor. The idea here is to exploit behavioral inefficiencies. Investors continually get overly pessimistic about certain areas of the market and they bid them down too much or they neglect areas considered “boring” (i.e., stocks that are less volatile and have predictable earnings in lieu of high-growth areas). Time and time again, whether you look at the last 100 years, whether you look at international markets or domestic markets, you see that those highflying growth-oriented areas, at times, underperformed cheaper areas of the market and those that have been less volatile over the long run. That’s why in particularly times like this where those sectors and securities are actually especially unloved, it’s even more important for creating long-term value.
How are you positioning portfolios for investors concerned about volatility today?
To generate long-term value, we look at characteristics we believe support long-term appreciation but also support downside management over the long run, including high earnings yield and high dividend payments. We tend to invest in the value bucket of the market, but focusing on those stocks with very low price and earnings volatility, so they are more predictable. That makes our strategy tilt towards typical sectors that tend to be non-cyclical, meaning they have less sensitivity to the overall business cycle. Downside management offered by more defensive equity strategies is particularly relevant as we move into a more volatile equity markets.
What are you selling?
Our systematic process has led us to sell out of stocks where dividends were no longer sustainable because the economic environment had changed their earnings or their volatility profile. We sold those names as we no longer viewed them as worth the opportunity in terms of that downside management.
Other examples of where we moved out of stocks systematically have been because we no longer viewed them as an opportunity from a valuation standpoint. An example is Boeing, which we bought in 2016 and essentially rode up over 180 percent – but its dividend yield, because of that significant price appreciation, declined quite significantly. When we first bought Boeing, the dividend was around 3 percent. When we sold it at the start of this year, it was under 1.5 percent. This is an example of systematically selling stocks that have done very, very well because in our fundamental view that value opportunity is no longer there.
Where are you deploying capital in?
We have continued to reinvest in underappreciated areas that remain sustainable. We moved into the Energy sector last quarter, going from a zero position in 2016 to more than 5 percent now as we continue to find opportunities in Energy. We are moving out of the Technology sector, increasing our underweight. We had around a 10 percent position before the quarterly rebalance. That’s down to close to 2.5 percent now as earnings stability in the Tech sector deteriorates.
We continue to buy the more underperforming and unloved sectors, particularly in the consumer-oriented areas. Utilities and Consumer Staples are two of the cheapest sectors in the S&P 500.
Michael LaBella is a Portfolio Manager at QS Investors, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.
1FAANG is an acronym for the market's five most popular tech stocks, namely Facebook, Apple, Amazon, Netflix and Alphabet’s Google.
2The International Monetary Fund (IMF) is an international organization that aims to promote global economic growth and financial stability, to encourage international trade, and to reduce poverty.
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