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The Spin on Stock Market Rotation

Since October, the stock market has given back all of its gain in 2018. The SPDR S&P 500 ETF (NYSE: SPY) fell 10% during the first eight weeks of the final quarter, reducing its year-to-date return from plus 8% to minus 2%.

At the same time, volatility has spiked and shows no signs of receding anytime soon. The CBOE Volatility Index (CBOE: VIX) doubled in value in just eight days. It reached its highest reading in October since January’s flash correction.

I warned this would happen back in July as the stock market reached record highs. We advised that investors should start shifting their portfolios “into investments that should benefit from inflation” since rising interest rates were clearly on the way.

I don’t know how many people took my advice then. But if you did not, then it’s still not too late to make an adjustment. That’s because many investors have accumulated huge gains in their stock portfolios over the past several years. They would prefer to wait until January to realize them. That way, they don’t have to pay capital gain taxes on them until April of 2020.

Of course, IRA owners and participants in other tax-deferred accounts have no such concern. Hence, we have already seen migration out of trendy momentum stocks such as the FAANG quintet of Facebook (NSDQ: FB), Amazon (NSDQ: AMZN), Apple (NSDQ: AAPL), Netflix (NSDQ: NFLIX), and Alphabet (NSDQ: GOOGL) that are heavily owned in pension funds and 401(k) accounts.

So, expect another wave of selling in early January when taxable accounts get in on the action. To make matters worse, later that month most companies will begin reporting fourth quarter and year-end results. The combined effect could be one of the most volatile months in recent history.

Rotation Is Not Capitulation

However, extreme stock market volatility does not necessarily equal capitulation. Just because money is being taken out of one set of stocks doesn’t mean it is coming out of the market altogether. Instead, I believe what we are witnessing is a rotation from one set of stocks to another.

Stock market rotation is a byproduct of “reversion to the mean.” That occurs when stocks that have become mis-priced start heading back toward their historical averages. However, that process is inefficient and usually takes many months — sometimes years — to complete.

During the heady days of artificially low interest rates in the aftermath of the Great Recession, growth stocks soared. They enjoyed abnormally high valuations since future earnings could be discounted at a very low rate. That is no longer the case.

As the Fed ratchets up interest rates in response to a tightening job market, earnings multiples are coming down. A few months ago, Amazon traded at roughly 80 times forward earnings. Today, that multiple is closer to 60.

That’s still a very high number. But the magnitude of its decrease is indicative of the degree to which investors have cooled on marginally profitable companies. Amazon’s 4% profit margin is razor thin compared to Apple’s margin of 22%.

Yet both stocks fell by about the same amount over the past two months. That’s despite the fact AAPL is now valued at less than 12 times forward earnings, or one-fifth Amazon’s earnings multiple.

Another company with a profit margin near 4% is Target (NYSE: TGT). And similar to AAPL, Target is valued at 12 times forward earnings. However, it pays a dividend yield of 3.8%, which is higher than the 3% yield on the 10-year Treasury note and considerably more than Apple’s 1.5% dividend yield.

However, Target got slammed last week after releasing Q3 results that came in below expectations. At a recent share price of $72, TGT is still in positive territory for 2018 but down 20% from its all-time high price of $90 achieved in September.

That makes Target a company with Amazon’s profit margin and Apple’s forward earnings multiple, plus a high dividend yield. Yet, it has returned less than 10% to its shareholders this year while Amazon is up more than 30%. Why is that?

Discounting DCF Models

Many theories abound. But as Occam’s razor stipulates, the simplest explanation may also be the most accurate. A lot of Wall Street analysts are still using a DCF (discounted cash flow) model to price stocks. Those models are starting to sag under the weight of rising interest rates and decelerating revenue streams.

Want proof? On November 28, Fed Chair Jerome Powell acquiesced to pressure from the White House by stating, “interest rates… remain just below the broad range of estimates that would be neutral for the economy.”

Analysts raced to reduce the interest rate at which future earnings are discounted to the present in response to Powell’s remarks. Predictably, stocks zoomed up more than 2% that afternoon.

Cause and effect in the stock market is seldom as obvious as it was that day. Of course, Powell’s comments may have reflected a pragmatic desire to keep his job more than a genuine change in his beliefs.

Even Powell would admit that while the Fed can influence the level of short-term interest rates, it has no control over the burgeoning federal deficit that will demand higher interest rates on the Treasury debt issued to service it down the road.

For that reason, I believe value stocks that pay a reasonable dividend yield will attract more investors in 2019 and beyond. As analysts plug increasingly higher interest rate assumptions into their DCF models, high-multiple growth stocks that pay little or no dividends will become less valuable.

The net effect will be a temporary decline in the overall stock market as its average earnings multiple reverts to the mean by coming down 10% or so. But within that universe of 3,000+ stocks that comprise the U.S stock market, there will be winners and losers.

A stock such as Target could see its earnings multiple revert to its mean by rising 20% at the same time. There are many other stocks that will benefit from stock market rotation in 2019. Figuring out which ones will be the key to posting positive gains while the market rotates from one set of winners to another.

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