Stock Cycles and Value
By Michael McKeown, CFA, CPA - Chief Investment Officer
“Reversion to the mean is the iron rule of financial markets.” – John Bogle, founder of Vanguard
On a cyclical basis, regional outperformance tends to beget outperformance. We call this the ability of markets to ‘trend,’ while our contemporaries describe it as ‘momentum.’ Yet it does not go on forever. The chart below displays how emerging markets and the S&P 500 have traded the lead over the past 29 years.
During past cycles, lasting six to eight years, there was dramatic outperformance by the winner. It started with emerging markets from 1988 to 1993, with the S&P 500 taking the lead during the technology bubble. Then emerging markets crushed with the commodity boom and decline of the dollar in the 2000s. The S&P 500 won the latest round coming out of the global financial crisis.
The pivots of the relative performance difference came at valuation extremes. Below we show the enterprise value to sales ratio. Enterprise value adds up both the market value of equity and debt for the market. Sales are a great metric because there are no accounting adjustments made to ‘massage’ the numbers, like earnings. One of our favorite contrarian managers uses this measure to try to find unloved companies that are at ten or twenty year valuation lows. This is where expectations are at the bottom of the barrel and most sellers capitulate. Because the financial sector has such different regulations from country to regions, we use indices that exclude the entire sector.
The chart below shows the latest Enterprise Value to Sales ratios. The United States is closer to its peak in the late 1990s than to the troughs in the mid 1990s or 2009. On the other hand, emerging markets look closer to the lows of 2002 and 2009. The bottom chart shows that the difference is more than one standard deviation than the historical average.
In 2016, the tide turned, with an essential tie on a total return basis. The turn in commodity prices, including oil, helped the stock markets of commodity exporting nations. The speed of dollar appreciation against these countries’ currencies also slowed. In turn, sales and earnings began to trough.
Even with the concern of protectionist policies by the new administration, the emerging markets showed resilience during January. One year does not make a trend, but there are signs that reversion to the mean is flexing its muscle.
This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.