The Case for Cyclicals in a Recovery

Where are we in the Recovery Cycle?

The pandemic shaved 1,201 points off the S&P 500 (~35%) between Feb 19, 2020 and March 23, 2020. The market then experienced the fastest recovery from a recessionary period in history, as the index surpassed those peak February levels in August. While the markets recovered quickly, a real return to normalcy has been anything but normal for the economy and individuals around the world who have been impacted by this virus.

While the first year of the pandemic focused heavily on developing a vaccine, quarantining, and mask mandates, the re-opening has been complicated by COVID variants and vaccination resistance from certain pockets of the country. As vaccine efficacy tests continue to show successful prevention from serious illness in large form, booster shots are on the horizon for many Americans who were vaccinated in the spring. The science continues to prevail, yet the global recovery is slow.

That brings us to today, where labor force is tight, supply shortages persist, rates are low, and liquidity is high. As the global economy works its way through a period of peak demand in Q2 and continued elevated demand, the dynamic favors cyclical companies in a drawn-out recovery. Yes, we are at peak growth and earnings, but we strongly believe that the excess liquidity, the friendly Fed and momentum in the economy will continue to lead to above trend growth. And while consumer confidence and sentiment has waned as of late (due to Delta unknowns), the weekly data that we look at suggests the consumer remains strong, home prices are high, and savings remain elevated.

Economic Growth and Elevated Demand Supporting Cyclical-Driven Recovery

Significant liquidity from easy monetary policy, fiscal stimulus, bank lending, and private investment has sparked solid growth and more inflation. Companies in need of employees to help meet elevated demand are using higher wages (4% annualized rate in July’s reading – we await August’s report this Friday) to attract people back into the workforce. Shelter costs continue to rise through July and make up nearly a third of total CPI. We continue to emphasize that wages and shelter costs are stickier inputs to inflationary pressure than commodities and elevated prices of durable goods. And while commodities may be transitory in nature, their decline to normal price levels is delayed from supply chain constraints and persistent shortages in certain markets.

Cyclical companies tend to grow with the economy and an extended recovery will provide extended growth support for those types of companies. As Delta variant headlines drive lower consumer confidence numbers, temporary fear can cause cyclicals to temporarily underperform the index. As confidence rises, businesses re-open, labor force grows, and demand stays high, cyclicals tend to outperform. The service economy continues to experience high demand and infrastructure stimulus should also provide an additional growth catalyst for many cyclical stocks. We’ve seen data indicating that companies are increasing their spend on enterprise solutions and view this as another confident outlook for the growth trajectory.

Upward broker revisions for cyclicals are outpacing all other sectors for periods in both 2021 and 2022. This includes revisions for revenue, margins, and earnings. We view this as another positive indication that an extended recovery will benefit the growth of cyclicals. Cyclicals also continue to offer attractive valuations and trade at -0.7x the market.¹

Continued Shifts in Outlook for Value & Growth

Referencing the chart below, value outperformed growth for most periods between the dot-com bubble and the housing crisis. Since the housing crisis, we’ve seen a reverse trend as growth has outperformed in most periods since. The indexed ratio of value/growth is now below levels from the start of this dataset (September 29, 2000). During the current recovery period, value had a strong period of outperformance in the beginning of 2021 before sentiment shifted to favor growth in the recent summer months. It’s been a long road of high-multiple, consolidated megacap outperformance in the market, and now that growth has made back all of value’s outperformance that occurred in the first part of the 2000s, it’s natural to ask: will there be a mean-reversion?

Over the past ten years, growth stocks have traded, on average, 2.6x P/E points above the market, today they trade at a 6.7x points premium! Our contrarian approach allows us to continue to find opportunities in companies at attractive valuations that are maintaining strong balance sheets, returning cash to shareholders, and taking advantage of secular growth opportunities. Lastly, between 2008-2020, inflation rate YoY touched 3% only once (2011) and averaged 1.6% – below the Fed’s current 2% target and well below the 2001-2007 average of 2.7% YoY.² Performance during periods of inflation have historically favored value and dividend yielding stocks.

Chart: S&P Value / S&P Growth Indexed Ratio (Indexed to 9/29/2000)³

A Continued Recovery

Delta seems to have peaked in certain areas, states are reporting individuals increasingly returning to the labor market, and easy monetary policy is contributing to higher growth and inflation. Q2 GDP numbers were revised to 6.6% and while that may be a peak, we can stay above trend for quite some time. The wage report this Friday will be an important indicator of continued, sticky inflationary pressures – numbers were hot for July as hourly earnings were up 4% annualized from the prior year.

As economic growth and inflation remain elevated, we believe this environment favors more economically sensitive companies with strong balance sheets, significant free cash flow, and operating leverage at attractive valuations. Many companies we follow have displayed strong pricing power to combat margin pressure and have also offered good visibility into 2022, providing confidence in their outlook. We continue to closely monitor the uneven recovery and our convictions align with a strong environment for equities and risk assets.

We don’t want to suggest only owning cyclicals/re-opening sectors and stocks, as diversification is always key in any portfolio. What we do believe is the valuation differential between cyclicals/re-opening/value vs. growth appears to be at an extreme and worth paying attention to. If we are correct in our economic thesis of above trend growth and inflation, a “catch up trade” could occur.

Stephanie Link: CNBC TV Schedule

Sources

1. Credit-Suisse
2. Bureau of Labor Statistics
3. FactSet

Disclosures

Investment Solutions at Hightower Advisors is a team of investment professionals registered with Hightower Securities, LLC, member FINRA/SIPC, & Hightower Advisors, LLC a registered investment advisor with the SEC. All securities are offered through Hightower Securities, LLC and advisory services are offered through Hightower Advisors, LLC. This is not an offer to buy or sell securities. No investment process is free of risk and there is no guarantee that the investment process described herein will be profitable. Investors may lose all of their investments. Past performance is not indicative of current or future performance and is not a guarantee. In preparing these materials, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public and internal sources; as such, neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Hightower shall not in any way be liable for claims and make no expressed or implied representations or warranties as to their accuracy or completeness or for statements or errors contained in or omissions from them. This document was created for informational purposes only; the opinions expressed are solely those of the author, and do not represent those of Hightower Advisors, LLC or any of its affiliates.