It’s time to buy cyclicals and small-caps. That’s been a bold call, especially for fund managers who have acquired a “hot-stove mentality” after being burned over the past 10 years. But this time, says Savita Subramanian,
Bank of America’s
widely followed strategist, outperformance could last for years, as it did after the tech bubble burst. Finding promising investments is even more important today, especially if the market itself delivers lackluster returns, as she expects.
A double major in math and philosophy at the University of California, Berkeley, Subramanian is a heavy user of quant data in her studies of investor sentiment, and has been chief strategist since 2011. She recently chatted with Barron’s about how the Biden administration will achieve economic growth, and why—despite being the firm’s head of ESG—she’s recommending energy stocks.
Read the following edited excerpts for more.
Barron’s: President Biden has issued dozens of executive orders. How should investors digest these?
Savita Subramanian: They represent a few thematic changes and a big break from the market leadership of the past four years. This administration is less focused on asset inflation and more on real inflation, in creating jobs and reinvigorating the real economy, rather than just bolstering stock market returns. From listening to this new administration’s rhetoric, they’re not looking at barometers like the
index or investment returns as a metric of success or failure. Instead, they’re focused on addressing some of the bigger inequities in the market, like income inequality. That means we’re going to see less-great market returns, but probably a bigger return in the economy overall.
Your market call is pretty tepid.
I’m one of the lowest forecasts on Wall Street. We’re looking for 3,800 on the S&P 500. It’s a very tech-growth-heavy benchmark. We’re looking for S&P earnings to grow by about 20% this year. Obviously, we’re expecting to see some multiple compression. We’re expecting to see a very strong economic recovery. Our economists Michelle Meyer and Ethan Harris are looking for 6% growth on U.S. gross domestic product. Most of that recovery should take place in the second half of this year as we see broad dispersal of vaccines and a more concerted, coordinated reopening. It’s hard to be bearish, given all the stimulus.
Here’s why we’re not bearish: Interest rates are superlow, U.S. large-caps offer great yields, relative to bonds, and the Biden administration is laser-focused on the economy. It’s hard to see a recession-driven bear market.
The market was gripped by the spectacular rise of
[ticker: GME]. What does it mean?
We’re seeing more and more of the decoupling of fundamentals from performance. It’s always troubling to see, and it smacks of speculation. A couple of things: All of the action seemed to be focused on the small-cap space. Companies with high short interest in the S&P 500 behaved normally, but those in the
behaved very atypically. The good news is this seems to be localized in smaller-market-cap stocks, so the impact is less extreme, and it’s emblematic of more speculative drama in the market, rather than in more fundamental investing.
What would make you more bearish?
If we saw interest rates rise meaningfully from here. A big portion of the investor base today is retirees looking for income, forced to buy the S&P 500. We’ve got really tight pockets of the market where you could potentially see an inflation spike. Two years ago, we polled all of our stock analysts to ask where they were seeing input cost pressure and pricing power, and the only two sectors they cited were utilities and health care. We did the same report a couple of months ago, and almost every analyst cited inflationary pressure.
Today, close to 70% of stocks pay a dividend that’s higher than the 10-year Treasury, which is very close to a record high. [The 10-year currently yields 1.12%.] If rates rise to 1.75%, which our economist is expecting, that proportion drops to 44%. And all of a sudden, that story vaporizes. That’s the swing factor. And that’s one reason we’re less optimistic about equities, not to mention all of the speculations we see.
The similarities between today and 2000 is democratization and retail participation in the market, the decoupling of fundamentals from price. The last time we’ve seen earnings surprises met with negative reactions, as we’re seeing now, was in March 2000. The other similarity is our sell-side indicator, a very good market-timing model that looks at Wall Street’s average recommendation to stocks in a balanced fund. That model is now spitting out close to 60%, which would be a sell signal, close to 2007 and almost exactly at the same level as March 2000. All of these ducks are lining up.
So, what should investors do?
Focus on GDP-sensitive areas of the market that haven’t done well for almost a decade. Our sector overweights include financials, energy, industrials, and health care. We find some pent-up manufacturing demand from an unprecedented paralysis in the manufacturing and services economy. We’re more bullish on business investment than on consumption of durable goods. Within consumption, we’re more bullish on a pickup in consumer services than a pickup in consumer goods. Based on our credit-card data for 2020, unlike in the usual economic recession, spending trends remain strong. We had the fastest bear market. The Fed, fiscal policy, and Corporate America basically stepped up and staved off what could have been a deeper recession. Spending took place in home goods and the higher-end consumption areas of the market. Those areas could be at risk in 2021. Our sector underweights are communication services, which are half-growth, half-bond proxies; real estate; and staples.
In 14 of the past 14 recessions, the recovery was led by value and cyclical. So, we’re going to see a value cycle. Growth stocks are overly discounting this low-rate, low-growth environment. An easier call to make than value is another area nobody wants to touch—smaller companies, because of liquidity, because of the oligopolistic market. We could be at the start of a longer-lived small-cap cycle, which tends to last eight to 10 years.
What about the technology and megacap parts of the market?
Coming out of the tech bubble, value outperformed growth for at least seven years. Some cycles last awhile.
What surprises me is how reluctant fund managers or institutional investors are to shed exposure to that past leadership when we’re at what looks like a break point in terms of the economy and the political environment. It’s the hot-stove mentality, because every year since 2008, where anyone has bet on rising interest rates and inflation, they’ve basically been smacked down.
More immediately, any potential reversal in Trump-era corporate tax cuts, which would make sense to fund all of the growth, would hit communication services and information technology: the two leadership sectors most overweighted by fund managers.
Let’s talk about ESG.
We’ve really seen a demonstrable and well-articulated pivot of Corporate America in terms of how they’re aiming to please. They’ve gone from shareholder to stakeholder returns. That’s huge. They’re articulating and essentially promising us they care about the communities in which they operate, their employees, and customer satisfaction beyond the bottom line. I don’t think it’s anticapitalist. But I think it’s a new way of thinking about capitalism. The corporate stimulus during Covid-19 was sizable, equivalent on some level to fiscal and Fed stimulus. It was at least $1 trillion of support from Corporate America. Companies repurposed manufacturing to create ventilators, engaged in loan forbearance for consumers, made monetary donations. My own company initiated layoff freezes. It quelled a lot of consumer fears.
There’s a learning curve that has been adopted by investors in terms of separating the real from the greenwashing. We’re also seeing big changes in the information that investors are being given about companies. Companies have realized that if they don’t publish a corporate sustainability report, they’re going to trade at a discount to their peer that does. So, that transparency and explosion in data is huge from an investor perspective. All of a sudden, you can codify all of these factors we once only thought about. But ESG is always going to be a messy process. There’s always going to be this interpretive element to it.
Yet despite being the global head of ESG for your firm, you’re overweight the energy sector.
Renewables companies have done well, despite the fact that we had four years under an administration that wasn’t focused on these themes. It’s really great that ESG investors today have an ally in the White House. Yet you don’t need mandates from Washington politicians to get going. Investors realized that the future is renewables and are slowly phasing out traditional commodities. But we still need to keep the lights on, and things going, to get to carbon neutrality. There’s an opportunity to buy traditional energy companies that are setting more-aggressive goals of environmental compliance, but are also providing much-needed fuels to keep, to reintegrate, the economy, because we aren’t at the point where we can do everything on wind and solar. So, we’re actually overweight energy, which draws a lot of raised eyebrows. I feel totally comfortable with that because energy companies are essentially reinventing themselves.
Write to Leslie P. Norton at email@example.com