Greg Johnson is an equity portfolio manager and principal investment officer of American Balanced Fund. He discusses his outlook for U.S. stocks and his reasons for wanting to lean against the stock market rally.
Q: What is your outlook on U.S. equity markets?
A: I am getting cautious on U.S. equities. We could be in the late stages of this economic and market cycle. We have gone an entire year without a 5% correction, which is unusual. The U.S. equity markets increasingly appear to be priced for perfection. Equity valuations, at least by historical standards, are high.
You can see our more cautious stance in our positioning. At the end of 2013, American Balanced Fund was at 74% in equities, it is now at 62% and I expect the equity allocation to come down further. I realize that we may lag if this bull market continues, but my focus is much more on protecting on the downside. As we all know, no one can precisely time the markets, but as this stock market continues to go up, my inclination will be to lean against it.
Q: What in this late cycle worries you?
A: Earnings are improving, but earnings quality is arguably not the best. If valuations were not stretched, it would be less of an issue, but the aggregate price-earnings multiple of the market, at more than 21, is high. As and when interest rates go up, that multiple becomes less sustainable.
Capital allocation decisions by corporations, as evidenced by their continued purchase of stocks, are not getting better. Total corporate debt is huge at something like $11 trillion. Credit spreads are tight. Sure, it is debt that has been raised at very low rates. But we are seeing covenants in new deals to be less friendly to buyers and more in favor of lenders. Additionally, about $8 trillion of bonds offered globally has negative interest rates.
As central banks start to unwind the quantitative easing program they put in place during the financial crisis, financial conditions can tighten. We may see inflation move higher as wages rise. Aggregate consumer demand has shown a sharp improvement in September. This could force the Federal Reserve to become more aggressive than it has been. Against this backdrop, if interest rates rise, the valuations become even less sustainable.
What worries me in terms of the structure of the markets is the sheer volume of money that is flowing into passive products such as ETFs (Exchange-Traded Funds), and the number of ETFs that are tied to narrow areas of the market. Correlations across asset classes have increased substantially. In a market selloff, it is not entirely clear how these products will behave and what the impact will be on the broader market.
Q: Technology has become a large part of the markets and many of our funds. It could lead a market decline just as it has led the rally. What are your thoughts?
A: Technology today is different from the era of the dot-com bubble. The dominant companies today have sustainable profits, strong cash flows and huge market share. Given the large capital expenditures they make every year in billions of dollars, they have high barriers to entry. I would argue that earnings for technology companies today are more stable than many other sectors of the market. If you look at some companies like Netflix, Amazon and Microsoft, they are almost subscription-like businesses.
One could argue that these companies are over-owned, as they are held by a broad cross section of investors including momentum strategies, growth funds and value funds. So yes, the stocks could be vulnerable in a market correction, but the long-term fundamentals remain quite strong. They have the strongest balance sheets, the greatest visibility of earnings and sustainable business models of any sectors in the market.
Q: What areas of the market are you gravitating to as you get more cautious on U.S. stocks?
A: The traditional defensive areas of the market — utilities and consumer staples — are not cheap at a price-earnings ratio of more than 20. I am more comfortable with holdings in financials. I think they will probably hold up better in choppier times in this cycle. The dividends associated with financials are much more sustainable, they have substantially increased their capital base, they have been conservative in their lending and the interest rate cycle is favorable to them. Energy is another area that is not as expensive, and given where valuations are today, many of these stocks may hold up better in a declining market.
Keep in mind that reversion-to-the-mean investing in this market cycle has not worked too well. Technology has been a huge disrupter in many industries and we have invested in many of these disrupters to the benefit of American Balanced Fund. That said, these stocks have had a huge run-up and have become a significant part of the momentum trades dominating markets today.
Growth stocks (as represented by the Russell 1000 Growth) have risen 23% year-to-date (through September 30, 2017) and value stocks (Russell 1000 Value) have risen 9%. That’s a huge gap. I believe that eventually, reversion-to-the-mean investing does work and that value investing is a sound principle. So I personally am trying to reposition the portion of the fund’s portfolio I manage to areas of the market that have lagged — in companies that are misunderstood or unloved by the market — like some of the commercial property REITS, or some of the financials.
Q: How are you thinking about the fixed income allocation in a balanced fund against this backdrop?
A: In American Balanced Fund, the primary role of the bond portfolio is to provide protection in a broad market selloff. So the bond portfolio is designed not to have a high correlation to the stock portfolio — that it generates some income but not at the cost of diversification. It is a high-quality, investment-grade bond portfolio. We have portfolio managers who are very hands-on in managing that portfolio, squeezing out singles and doubles from duration and credit positioning with the aim of delivering an excess return above market benchmarks. But they do this while staying focused on the overall objective of fixed income, which is to provide the diversification from equities. This allows us to have a more aggressively positioned stock portfolio than we would otherwise.
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