Consider Selling Momentum, Buying Contrarian

Wednesday, January 15, 2014, Vol. 129, No. 10

The S&P 500 has been the world’s performance bell cow since the great recession on the relative strength of the U.S. economic recovery. The S&P 500 has outperformed the MSCI All World ex USA All Cap Index by 17 percent over the last year, 11 percent annualized over the last three years and 5 percent annualized over the last five years.

This dramatic outperformance has pushed U.S. index valuations above long-term averages. Periods of overvaluation can persist for prolonged periods. However, fundamental investors tend to grimace when valuations appear stretched. While the stock market may maintain its upward bias on earnings and economic growth, prudent investors should consider selling higher valuation quadrants to buy lower valuation quadrants after such a strong run.

Theoretically, this should improve upside potential and decrease downside risk.

The proliferation of index linked mutual funds and ETFs, coupled with strong performance for markets overall has fostered over-subscription among major index components. The market period between 1995 and 1999 serves as a corollary (although with more extreme dynamics). During that period, strength in the US economy, strength in the U.S. dollar and rapid innovation in Silicon Valley made US growth stocks irresistible, which led to oversubscription and financial abandonment of nearly everything else. Between 1995 and 2000 large cap growth stocks compounded money at 31 percent a year versus 15 percent for small cap value stocks. At the height of the momentum madness, the Nicholas Applegate Global Technology fund gained nearly 500 percent in 1999. That same year Warren Buffett’s Berkshire Hathaway lost nearly 20 percent. Many publications jumped on this disparity accusing Warren of losing touch with the modern marketplace. In truth, Warren’s fundamental contrarian style conflicted with the momentum dominated environment of the day. As the momentum trade gave way in 2000, Warren’s fundamental approach regained favor. In 2000, as growth and tech funds experiencing significant declines, Berkshire Hathaway gained 27 percent. Over the next five years the large cap growth category declined 5 percent annually as small cap value stocks gained 22 percent annually.

To parlay this reasoning forward, investors should engage in “relative” analysis to locate areas inexpensive market quadrants “relative” to Large Cap U.S. stocks that have held the momentum magic. The S&P 500 has gained 18 percent annually over the last 5 years but the period has not been as kind to large financial companies up 14 percent annually. The underperformance of the financials becomes even more pronounced over a 10-year look back. While the S&P 500 has appreciated nearly 8 percent annually over the last 10 years, the US financial sector has appreciated only 1.4 percent annually. Currently, financial valuations are below both the S&P 500 valuation overall and their long term average.

David Waddell is president and CEO of Memphis-based Waddell & Associates.