Market Taking Wave 3 in Stride; Further Upside for Epicenter
Coming out of the first week of December, overall trends in both financial markets and even macro are mostly positive. And despite COVID-19 still expanding in Wave 3, albeit at a much slower pace, financial markets are taking this in stride. And I see multiple tailwinds for risk assets and epicenter stocks in particular. More on this below.
On the COVID-19 front, Wave 3 is still raging across the US and our base case remains that it will not peak until Feb 2021 — essentially following the forecast of the IHME (healthdata.org) and the work of Dr. Chris Murray.
But at the same, there are some characteristics of Wave 3 that we are watching. Wave 3 swept across parts of the US previously unscathed in Wave 1 and 2, including many parts of CA and TX. It was initially led by 6 states, WI, IL, ID, ND, SD, UT, or WIINSU. And within WIINSU daily cases are rolling over.
So here is the key question — will Wave 3 peak when the Wave 1 and Wave 2 ‘unscathed’ regions rollover?
See the red line states in the chart nearby? Those are daily cases per 1mm for WIINSU. They are rolling over and the surge is now in Wave 1 and, to a lesser extent, Wave 2 states. And interestingly, when looking at county-level diffusion data, we see a similar picture. The diffusion (or % of counties, based on population) where COVID-19 cases are lower vs 7D ago has been increasing. This is a positive development as the higher the figure, the better, as it indicates COVID-19 is in retreat.
This naturally begs the question of whether or not Wave 3 has peaked geographically? And while I don’t know the answer, the last time we saw the diffusion data increasing, it coincided with Wave 1 and Wave 2 peaks and could be indicative of an early trend.
STRATEGY: Do valuations justify a further rally in epicenter stocks?
We have seen a continued violent rotation into Epicenter stocks. In just the past month alone, the performance gap between SPHB (a proxy for epicenter stocks) vs FANG is about 2,500bp. So, naturally, many have been calling into question the longevity of this epicenter rotation and whether or not valuations justify a further rally? This is a good question.
After all, many have argued that Value stocks have languished because they don’t grow. So, this week I asked our data science team, led by tireless Ken, to look at the factors behind the massive outperformance of Growth (vs Value) since 2007. And the insights can be summed up pretty quickly: Almost all of the outperformance of growth is due to valuation expansion.
- Since 2007, the Price to Book Value Ratio (P/B) for Growth stocks expanded from 3.9x to 10.0x, or about a 156%. The P/B ratio for Value stocks was essentially flat increasing from 2.0x to 2.2x.
- Since 2007, the Price to Sales Ratio (P/S) for Growth stocks expanded from 1.7x to 4.3x , or about 150%. The P/S ratio for Value stocks increased from 1.3x to 1.8x, or about 40%.
You get the point. About 3/4 or >75% of the outperformance of Growth is due to valuation expansion. And as I have noted over the past few months, I see multiple factors supporting a sustained improvement in the valuation of Epicenter stocks.
To name a few: Operating leverage (aka cost cutting) will likely drive an EPS surprise to the upside. Equity risk premia should fall as these companies have proven “unkillable”. The US is early in the recovery cycle and GDP could surprise to the upside. Asset heavy stocks should outperform in an inflationary environment. And de-urbanization trends driven by millennials are driving a move towards asset heavy.
Context is also important. Zooming out on this epicenter rally, the YTD differential between FANG and Epicenter is about 7,000bp. So, we are only seeing ‘baby steps’ so far with the 2,500bps of outperformance in the past month.
Looking at the GICS 4 list (see chart nearby)., a significant number of industries are still 20% or more off their 2020 highs And given the strong prospects for valuations expansions, I don’t see 2020 price highs as a constraint for buying Epicenter stocks.This week, we updated our Trifecta Epicenter stock lists which is based on positive views coming from the trifecta of: (i) Quant (tireless Ken), (ii) Global Portfolio Strategy (Brian Rauscher, aka Rocky) and (iii) Technicals (Rob Sluymer). I encourage you to refer to this list for actionable ideas
Bottom Line: I see several factors supporting a sustained improvement in the valuation of epicenter stocks and 2020 price highs should not be seen as a constraint.
Figure Comparative matrix of risk/reward drivers in 2020
Per FSInsight
Figure: FSInsight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019
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