Now is the time to focus on cyclical stocks

Portfolio manager and MoneyLetter columnist John Stephenson says that despite persistent worries over valuation, there is no historical or economic reason to fear a market sell-off anytime soon. For that reason, investors should continue to overweight stocks and to focus on cyclical stocks in their investment portfolios.

Cyclical_StocksMarkets around the globe surged either to fresh records or multi-year highs in 2017, establishing the rally as one of the longest and broadest in years. Half of the 35 major indexes, representing the world’s biggest stock exchanges by market value, hit all-time highs last year, the most since 2007. In the US, the Dow Jones Industrial Average logged 60 record closing highs in 2017, the most since 1995, while the NASDAQ Composite gained 28 per cent and set 69 new highs, the most ever in a calendar year.

Overseas, the FTSE 100 in the UK and South Korea’s KOSPI index set new records last year, despite the geopolitical uncertainty ravaging those regions. India’s benchmark stock gauge also surged to new highs, standing out from many other emerging markets, owing to renewed investor confidence in the country’s political and economic stability.

Japan’s Nikkei Stock Average surged to a 21-year high, Hong Kong’s Hang Seng surpassed 30000 for the first time in a decade, and the Taiwan Capitalization Weighted Stock Index (TAIEX) traded at its highest level since 1990.

The reason? The global stock rally is a culmination of improving corporate earnings, strengthening economies and supportive monetary policies from central banks around the world. Market volatility has fallen to historic lows, and investors have used nearly every dip as a buying opportunity. And despite lofty valuations, conditions are ripe for the rallies to continue.

One of the very few outliers: Chinese stocks. The Shenzhen Composite, made up of many manufacturing and tech stocks, fell into negative territory recently, as Chinese authorities took fresh steps to halt the proliferation of small online lenders, moves that weighed on the market.

Why the frenzy?

Outside of China, economic growth is the reason for the rise in global markets. The International Monetary Fund (IMF) raised its global growth forecasts to 3.6 per cent for 2017 and 3.7 per cent for 2018, both up a tenth of a per cent from prior estimates. The IMF has also stated that recent growth has been more broad-based than at any point since the beginning of the decade. Further, only 13 countries globally are in recession, the fewest ever.

America has benefited, registering its best six-month stretch of growth in three years. In Europe, a measure of consumer sentiment rose hitting its highest level since April 2001. And in Asia, tech stock giants Alibaba Group Holding Ltd. and Tencent Holdings Limited, have surged so much that tech stocks overtook financials this year to become the biggest sector in the MSCI Emerging Markets Index for the first time since 2004.

A crisis policy without a crisis

The return to growth and reduced market volatility have been aided by stimulative central banks.  The Bank of Japan and European Central Bank have been overly accommodative since the recession. And despite the fact that the US Federal Reserve has raised interest rates four times, treasury yields and mortgage rates remain near historic lows. In essence, we have a crisis-like monetary policy, even though the crisis has long passed.

The hallmark of this global rally is its consistency. The MSCI All Country World Index has jumped to record highs, having risen for a record 12 consecutive months through October.  That’s its longest streak in at least 30 years. It has never risen every month for a full calendar year, but it’s expected to maintain its pace to do exactly that.

Without doubt, there are plenty of things to worry about. Geopolitical risk is a huge factor in the US-North Korea situation. And valuations are more elevated than usual in many parts of the world.

Global markets are also marked by extremely low volatility. The so-called fear gauge, the VIX Index, has been hovering just below ten for some time—an absurdly low reading. Since 1990, MSCI’s world index has had 43 different corrections, commonly defined as 10 per cent drops from recent highs. But none of these corrections started when the VIX was below 15.

In general, low volatility is consistent with higher multiples. Recessionary risks are extremely muted, and credit spreads remain tight. All this supports the case that volatility will remain subdued, and global equity markets will likely continue moving higher for the foreseeable future.

What I Recommend

With stock markets likely to move higher in the months ahead, investors should continue to over-weight cyclical stocks.

Blackstone Group

One company that fits the bill is the Blackstone Group L.P. The Blackstone Group L.P. (NYSE—BX) was founded in 1985 by Stephen A. Schwarzman, present chairman and CEO of the company, and Peter G. Peterson. Blackstone is an alternative asset management and financial services company. It is an independent manager of private capital worldwide, with US$333.9 billion in Assets Under Management (AUM) as of September 30, 2015. Headquartered in New York, Blackstone has 25 offices in the United States and around the globe.  Shares of the company present one of the most attractive exposures to alternative asset managers. With a deep bench of talent, a focus on reinventing its businesses constantly, and a global footprint, we believe Blackstone is able to generate strong fund performance and raise more capital than its competitors. In addition, the stock boasts a juicy dividend yield of 7.2 per cent, making it ideal for income starved investors. I have a Buy rating and a twelve-month price target of $37.50 per share for the Blackstone Group LP.

Brookfield Asset Management

Brookfield Asset Management (TSX—BAM.A) is another alternative asset manager that is Canada’s globe-trotting answer to Blackstone. Brookfield Asset Management is a global alternative asset manager focused on property, power and infrastructure assets. The company has ~$265 billion of Assets Under Management ($120 billion of which is fee-bearing), including premier office properties, power-generating plants, electricity transmission, transportation and distribution assets and various private equity funds. The company’s business model seeks to capitalize on its global reach to identify and acquire high quality ‘real’ assets at favourable valuations, and finance them on a long-term, low-risk basis. Operating expertise is applied to enhance the cash flows and values, such that BAM can earn reliable, attractive, long-term total returns for the benefit of its capital partners and its own account. BAM has a range of public and private investment vehicles that provide competitive advantages in the markets where it operates. I have a Buy rating and a twelve-month price target of $65 per share for Brookfield Asset Management.

Alibaba Group

For those investors who are a little more adventurous, I recommend Alibaba Group Holding Limited (NYSE—BABA). Alibaba is an online and mobile commerce company. The company runs a platform for third parties and does not take part in direct sales, hold inventory or compete directly with its merchant base. Alibaba’s retail marketplaces platform (Taobao, Tmall, and Juhuasuan) currently serves: 1) 350MM active buyers, and 2) 8.5MM active sellers. Alibaba also operates wholesale marketplaces (Alibaba.com, 1688.com), a global consumer marketplace (AliExpress), and provides cloud computing services (Aliyun). Almost all (90 per cent+) of Alibaba’s revenue has been generated in China to date. With digital commerce exploding worldwide, and with the Chinese consumer playing a more significant role in China’s economy, Alibaba is sitting at a unique nexus to exploit that growth. I have a Buy rating and a twelve-month price target of $225 per share on Alibaba.

Despite the persistent worries over valuation, there is no historical or economic reason to fear a market sell-off anytime soon. For that reason, investors should continue to overweight stocks and to focus on cyclical stocks in their investment portfolios.

John Stephenson is an award-winning portfolio manager and the President and CEO of Stephenson & Company Capital Management Inc. in Toronto. He is the author of “The Little Book of Commodity Investing” and “Shell Shocked: How Canadians Can Invest After the Collapse”. He is also the publisher of Strategic Investor (www.StephensonFiles.com). He can be reached at (647) 775-8360 or (844) 208-8817, or jstephenson@stephenson-co.com.

This is an edited version of an article that was originally published for subscribers in the December 2017/First Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.

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