I have an opportunity to co-teach a course in portfolio management with a local finance professor. As a result, I am required to return to my finance roots and think about markets from an academic perspective. Last weekend, our class discussed how to determine the value of a stock. While there are many methods for determining a stock’s fair value, one of the most widely used is the discounted cash flow or DCF model.
Class in Session
The DCF formula is a present value calculation. It is a way of discounting future cash flows to the present using a discount rate equal to a risk-free rate, the rate of inflation and risk premium desired for owning stock. (C’mon, stay with me just a little longer!) A company’s cash flow can be measured many ways, but generally it is a function of operating earnings. In order to estimate a company’s stock price we must have some idea of what those future operating earnings might be. Often, investors use past earnings growth to determine what the future may look like. To determine whether earnings will grow faster or slower, investors use inputs about the future economic outlook, as well as the business outlook for the sector or industry the company is in. From this description you can see how things like interest rates, inflation, economic performance and earnings affect stock prices.
Because stock investors use models that incorporate future earnings to determine their value, the movement in stock prices is inherently forward looking. In fact, when you look at the Leading Economic Index (published by a non-profit research group known as the Conference Board), one of its 10 components is the movement in the Standard & Poors 500 stock index. By looking at how stock prices move, we may be able to discern investors’ perspective on future economic and earnings performance.
In addition, while most pundits on the nightly news talk about the market as a whole, it may be instructive to look at its components to determine what types of stocks investors favor. This can present a different view than the one you get from looking at the whole market.
That is the case today. The S&P 500 stock index is up 9.4% from October 1 of last year through the end of February. The strong performance of the economy, both here in the U.S. and abroad, has led to those gains. We also know that the November election produced a result which has led to an increase in positive consumer sentiment and business optimism. Consumers and business owners alike would benefit from tax reform and the prospect of a friendly business environment. Because stock prices lead the economy, this improvement in the outlook has led investors to upgrade their expectations about future earnings.
What is interesting, though, is that leadership in stock price performance has changed over that five-month time frame. The tables below provide the data necessary to look at this change.
As you can see, during the fourth quarter of 2016, value stocks did very well and small cap stocks outperformed large cap stocks by a wide margin. The small-cap value index was up over 12% during the quarter as compared to large-cap growth stocks, which were actually down .31%. As the New Year began, a very different group of stocks started leading the market. For the first two months of 2017, growth stocks have been the better performers, with large-cap growth significantly outperforming small stocks, value in particular.
When we see this kind of stock performance rotation in a relatively short period of time, we try to understand investors’ rationale. It is possible that the primary reason for the change is that those stocks that didn’t participate as much in last year’s late rally were the less expensive alternatives for new money entering the market seeking to participate.
However, it may also be possible that the change in market leadership is a reflection of concerns about the economy’s ability to continue to improve its performance later this year. It may also be an acknowledgement that while fiscal policies are going to change, the timing is uncertain. At the very least, the stocks currently taking a leadership role generally do better when investors are interested in taking less risk, not more. Companies whose balance sheets have more cash and less debt begin to be favored by investors over those that are highly levered or who may have greater earnings volatility, such as smaller companies.
In 2016, value stocks outperformed as investors saw an economic recovery take hold. Stocks in the energy and financial sector benefit from better economic growth and last year, improved due to higher oil prices and higher interest rates. As we begin 2017, investors aren’t interested in leaving the stock market. Instead, they have rotated to sectors less cyclical such as healthcare and technology.
With energy prices and interest rates higher, inflation rising and a tighter monetary policy, the benefits of improved fiscal policy coming from the Administration and congress may be fighting tighter financial conditions.
All this highlights the benefit of our approach to portfolio construction. We use a diversified approach both in terms of asset type, like stocks and bonds, and also stock type. We use large, mid, small, growth, core and value stocks in portfolios. Our economic and market research provide us insight into which market segments to emphasize.
We combine our academic knowledge with insight into the direction the economy and markets will take to construct portfolios that we hope achieve our clients’ objectives.