Volatility is on the rise in the global financial markets. Last week’s roller coaster move ended with the Dow Jones Industrial Average in the red for the year.
“‘Whiplash’ is how one veteran investor described [last] week’s market,” Goldman Sachs’ David Kostin wrote. “S&P 500 fell 1.5% on Tuesday as the IMF’s newest World Economic Outlook discussed the weak prospects for global growth. Wednesday registered 2014’s best daily return (+1.8%) supported by the release of Fed minutes that noted US growth “might be slower than they expected if foreign economic growth came in weaker than anticipated”. The clear implication: Interest rates might be held lower for longer than market participants expected. This comfort was short-lived — S&P 500 sank 2% on Thursday and 1% on Friday.”
Kostin believes that investors and traders can still make money in this market. His team’s 12-month target for the S&P 500 is 2150, which implies double-digit returns.
For the near-term, Kostin recommends three strategies:
(1) Focus on “American economic exceptionalism”. The world lacks growth, but our economists forecast US GDP will accelerate to 3.2% in 2015, the fastest rate of expansion since 2005. Meanwhile our economists expect Euro area growth of just 0.7% this year and 1% in 2015. US stocks with a high proportion of domestic sales have and should continue to benefit disproportionately relative to firms with a high share of foreign revenues. The performance YTD of US-facing firms versus stocks exposed to Europe totals 1055 bp (+7.5% vs. -3.1%), with 74% of the excess return coming since mid-year (780 bp).
(2) Focus on sectors that benefit from lower oil prices. Energy earnings closely follow oil price changes. Brent plunged 20% since June and Energy stocks fell by 11% while S&P 500 slipped only 1%. Without a rebound in crude prices, Energy equities will continue to lag. However, lower oil prices benefit non-energy sectors, particularly Consumer Staples and Discretionary, as input costs decline and personal consumption potentially rises. Other industries such as chemicals and airlines also experience reduced input costs. Investors should overweight Industrials and Consumer Discretionary.
(3) Stick with large-caps despite the siren call of small-cap US equities that have dramatically underperformed. A strengthening US dollar and positive US GDP growth often correspond with Russell 2000 outperformance. However, negative earnings revisions have actually increased small-cap valuations even as share prices have declined. The tight relationship between Russell 2000 relative performance and the slope of the US yield curve highlights the degree to which concerns over growth and Fed policy have biased investors toward the relative safety of large-caps.
US economic outperformance and cheap oil are familiar themes.