Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.
EQ: Stocks have trended higher since the Trump administration unveiled the framework of its tax plan about two weeks ago. Is the market starting to price in tax reform now?
Stovall: Yes, I believe that it is pricing in tax reform from an optimism perspective, but not yet from an earnings perspective. That’s because there really is no detail yet surrounding the plan that can be plugged into analytical models. So, right now it’s simply pumping up investor enthusiasm but is yet likely to have an effect on earnings estimates.
EQ: Earnings season kicks off this week with backs set to report. Have estimates moved in the past week?
Stovall: Well, they’ve certainly moved, but not in a favorable fashion. The S&P 500 is now expected to post a 2.7% gain in third-quarter earnings, which is down from the 5.0% advance that was expected as of Sept. 29, and well below the 8.4% rise that was anticipated at the end of the second quarter. So, it seems as if comparisons are getting a lot tougher, but we also are likely to see the effects of the hurricanes on many of the insurance companies. That is really what’s dragging down the earnings estimates. In particular, the Financial sector, which was expected to post a 1.2% increase in earnings, is now expected to see a more-than 11% decline.
EQ: In this week’s Sector Watch, you looked at the outperformance of momentum investing, particularly the Industry Momentum Model Portfolio by CFRA. Can you tell us more about the portfolio?
Stovall: The premise is that you let the market take you where it wants to go, or as I wrote in my book, The Seven Rules of Wall Street, the first rule is to let your winners ride. What this portfolio does is it identifies those sub-industries in the S&P 500—of which there are about 130—that are in the top 10% in terms of price change over the past 52 weeks. So, a sub-industry is added to the portfolio when it is in the top 10%, and is then removed from the portfolio when it falls out of the top 30%.
Since there were not enough sub-industry ETFs available to mimic this strategy, what I do is select a company to serve as a proxy for each of these sub-industries. These proxies are selected based on their CFRA STARS ranking, which is our investment outlook model. If there is a tie, then it’s decided by the highest STARS-ranked company with the greater market cap.
EQ: How did this portfolio compare against its benchmark?
Stovall: The portfolio has actually done relatively well. Since inception on April 30, 1999, the Industry Momentum Portfolio has done a compound annual rate of growth of 12.5% versus the S&P 500’s gain of 8.4%. In addition, the portfolio beat the S&P 500 essentially in two out of every three years. Granted, past performance is no guarantee of future results.
EQ: In terms of the momentum stocks, which groups and names fit the bill right now?
Stovall: Yes, and you might not be surprised by three of them, but probably by the fourth one. The sectors that have the greatest number of sub-industries within the Industry Momentum Portfolio include Consumer Discretionary, Technology and Industrials. In addition, some people might not assume that Financials would be in there, but they are. Essentially, it is those areas that have done well in terms of improvements in earnings, expectations of benefiting from tax cuts as well as infrastructure spending, and then also benefiting from a reduction in regulatory pressures. I guess you could say that these certainly are the stocks that have done well thus far in the Trump administration.
EQ: Momentum has been the predominant theme thus far, and it seems the trend continues to be your friend.
Stovall: Yes, it does, but those trends don’t last forever. When this market does end up stumbling, then the Industry Momentum Portfolio may stumble as well, and as a result, it has a standard deviation (which is a measure of volatility) that is relatively equal to that theme in the S&P 500. So, it definitely is not a low-volatility portfolio approach.