<

Why the US labor recovery supports equities and high yield credit

Part 11
Why the US labor recovery supports equities and high yield credit (Part 11 of 13)

Growth outperforms, supporting the below-investment-grade CIT Group

Value versus growth

The below graph looks at the performance of value versus growth indices compared to much broader indices—the Russell 2000 and the S&P 500. While the broadest of indices, the Russell 2000, outperformed all other indices, it’s important to note that, relative to the S&P 500, the Growth Index outperformed both the S&P 500 and the Value Index, and that the Value Index was the lowest-performing index of all. This pattern suggests that, in the case of economic recovery and rising stock prices, exposure to growth companies may outperform value companies, and that the broadest index exposure to a larger number of smaller companies in general, as reflected in the Russell 2000 index, may offer the best upside potential. Even with 4,000,000—or 4%—of the available workforce leaving the workforce since 2008, consumption data in the U.S. has remained robust, and growth stocks have continued to rally, in textbook fashion, out of the 2008 crisis market bottom.

Broad Market Indices vs Value  Growth IndicesEnlarge Graph

To gain a broader understanding of the other macroeconomic factors supporting the economic and investment-related views in this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.

Value stocks outperform growth stocks in the long run

Despite the recent outperformce of growth stocks in the post-2008 economic recovery, in the long run, and over several business cycles, academic studies tend to show that value stocks outperform growth stocks. One value versus growth study, by Chan & Lakonishok, involving data from 1969 to 2001—the peak of the dot com bubble growth stock phase—showed that, even during this period, smaller-value companies outperformed growth stocks by 18% over this 22-year period.

Value stocks tend to hold up better in declining markets

Plus, as the below chart demonstrates, during weak equity market periods, such as the DotCom crisis of 2002 or the financial crisis of 2008, value stocks held up much better than growth stocks, and they tend to do so when the future direction of the economy looks bleak.

Large Cap Value Growth  MomentumEnlarge Graph

As a result, investors concerned about a major decline in global equity prices or suddenly weakening economic data may wish to consider weighting value shares over growth shares in their portfolio. Alternatively, if investors are confident that global economic growth will remain firm, and that earnings will remain strong, an allocation to growth stocks over value stocks may be more appropriate.

To see how fixed income ETF performance varies depending upon credit quality and the duration of portfolio holdings, please see the next article in this series.

To learn more about these and other fixed income ETF investments, please see Fixed income ETF must-know: Has the bear market in bonds begun?

Credit Comment: CIT Group—Below investment grade financials continue to recover

CIT has a market capitalization of $9.57 billion (the value of all its equities) and is considered a high yield credit. Its debt is considered below the investment-grade cut-off of “BBB” rating, as it’s in the BB (junk bond or below–investment-grade) category. Reducing the firm’s $23.17 billion of debt by the $6.18 billion of cash holdings leaves approximately $17 billion of net debt, and a 1.77 debt to equity ratio. CIT Group currently has a February 19, 2019, senior unsecured bond yielding 3.46%, versus Sprint’s August 15, 2007, senior unsecured bond yielding 2.95%, Verizon’s February 15, 2008, senior unsecured bond yielding 2.00%, T-Mobile USA’s February 19, 2019, senior unsecured bond yielding 3.00%, and Caesar’s Entertainment’s June 1, 2017, senior secured bond yielding around 11.00%.

An improvement in labor and credit conditions would likely improve CIT Group’s credit rating—though with a BB- senior unsecured bond yielding 3.46% versus T-Mobile USA’s BB- company-guaranteed bond yielding 3.00%, CIT’s unsecured yield reflects a strong fundamental credit (Bloomberg & Capital IQ, December 31, 2013 Quarter).

Equity outlook: Cautious

Should the debt ceiling debate re-emerge after the mid-term elections in November, and macroeconomic data fail to rebound in sync with record corporate profits, investors may wish to consider limiting excessive exposure to the U.S. domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples-related shares, as reflected in the iShares Russell 1000 Value Index (IWD).

Plus, even the global blue chip shares in the S&P 500 (SPY) or Dow Jones (DIA) could come under pressure in a rising interest rate environment accompanied by slowing consumption, investment, and economic growth. So investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY) or the State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until there’s greater progress on the budget and federal debt issue, and consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution and consider value and defensive sectors for investment, or individual companies such as Wal-Mart Stores (WMT).

Without sustained improvement in economic growth data, there’s little doubt that the debt level issue and tax reform will be a big issue later in the year. Current economic data noted in this series suggests that the probability of the 2013 sequester issue returning—in one form or another—could be higher than many think. The data is simply not that robust—yet.

Equity outlook: Constructive

However, if investors are confident in the ability of the USA to sustain the current economic recovery as a result of the improving macroeconomic data noted in this series, they may be willing to take a longer-term view and invest in U.S. equities at their current prices. With the S&P 500 (SPY) price-to-earnings ratio standing at 19.65 versus the historical average of around 15.50, the S&P is slightly rich in price—though earnings have been solid. However, with so much wealth sitting in risk-free and short-term financial assets, it’s possible to imagine that a large reallocation of capital that is “on strike,” including corporate profits, into long-term fixed investments. This could lead to greater economic growth rates and support both higher equity and housing prices as well. In the case of a constructive outlook, investors should consider investing in growth through the iShares Russell 1000 Growth Index (IWF) or through individual growth-oriented companies such as Google (GOOG).

The Realist Discussions