Portfolio resilience, meet quality growth

Key takeaways

• Stocks have maintained year-to-date gains
• U.S. and global indices are up more than 7% in 2023

Russ Koesterich, Managing Director and Portfolio Manager of Global Allocation discusses the case for targeting more resilient parts of the market going forward.

Despite a mini-banking crisis, stocks have maintained year-to-date gains. While most equity markets peaked in early February, both U.S. and global indices are still up more than 7% in 2023. Certain segments, notably U.S. mega-cap tech stocks, are up more than 30%.

Given the magnitude of the gains, should investors be chasing the market or trimming exposure? My view is that stocks are likely to end the year higher but there are obstacles along the way. This suggests buying the dip rather than chasing the rally and targeting more resilient parts of the market.

Back in mid-February I suggested that stocks could go higher but, rather than chasing January’s low-quality rally, investors should instead focus on quality, stable growth, and growth at a reasonable price (GARP). Since the February peak, large-cap growth, specifically technology companies, has outperformed while more volatile, “early” growth has surrendered a significant portion of their January gains. I can see three reasons this dynamic is likely to continue:

Soft earnings growth. Starting with earnings, growth companies, particularly more mature growth companies, generally outperform when the economy is softening. This is the environment we’re facing today. Earnings estimates for the S&P 500 have been grinding lower as economic growth slows on the back of tighter financial conditions and credit. As a result, since last fall S&P 500 earnings estimates are down around 5%.

Stretched valuations. Lower earnings and strong year-to-date performance have created a second headwind: Valuations are well off the October lows and no longer cheap. The S&P 500 is trading for approximately 17x next year’s earnings. Valuations have also risen globally, as international markets have enjoyed even larger rallies. For example, since bottoming in October the Euro Stoxx 50 Index of European companies is up roughly 30%. The MSCI World Index is now trading at approximately 16x forward earnings, slightly above the long-term average (see Chart 1). While valuations are a poor short-term timing tool, investors need to take note that stocks are not nearly as cheap as they were six months ago.

Global equity price and earnings

The junk rally likely over

The end of the volatility trade. At the start of the year investors abruptly pivoted from favoring low volatility, defensive companies to embracing the most speculative names and market segments. The ensuing “junk rally” made the volatility factor, i.e., companies with higher volatility than the market, the best performing style tilt in January. That trend did not survive February’s backup in bond yields or March’s mini-bank crisis. Given prospects for slower growth and tighter credit markets, I have a hard time seeing the January vol trade re-emerging.

All of which suggests that investors should avoid aggressively chasing valuations higher. Instead, I would focus on adding to equity positions on weakness and concentrating on parts of the market best positioned to thrive in an environment of slower growth and tighter credit. To my mind, this favors higher quality, mega-cap growth companies. And if they are trading at a reasonable valuation to their peers and their history, i.e. GARP names, even better.

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