There are two big macro trends impacting global financial markets. U.S. economic growth is accelerating and inflation expectations are falling. Evidence abounds. Consider these year-to-date stock market sector and sub-sector returns:
- Energy stocks (XLE) are down -15%
- Biotech shares (IBB) are up +19%
Why Energy Stocks are Down...
It doesn't get more clear cut than that. Energy stocks are, obviously, tethered to the price of oil, which is down about -25% this year. Energy prices carry a 10.5% weighting in the Consumer Price Index, which slowed for the third consecutive month in May, decelerating -32 bps to +1.87% year-over-year, the slowest rate in 7 months.
Why Biotech stocks are up...
Meanwhile, Biotech stocks are closely tied to economically-sensitive debt funding cycles. The quest for the next big drug requires not-so-profitable companies to seek capital for development. The U.S. economy fell from 3.3% year-over-year in the first quarter of 2015 to 1.3% in the second quarter of 2016. On a related note, biotech-related IPOs crashed from $2.7 billion in the second quarter of 2015 to $400 million by the first quarter of 2016.
Valuation Is Not A Catalyst...
Our call is for the U.S. economy to continue to rise throughout 2017 and for inflation to continue to fall. So expect Energy stocks to continue to underperform and Biotech stocks to continue to outperform.
But aren't Biotech stocks expensive and Energy stocks cheap? Yes... but, question for you, who cares? Cheap stocks can get cheap and expensive stocks can get more expensive when prevailing trends continue to push stocks in either direction. Put simply: Valuation is not a catalyst.
Let's take a closer look.
Hedgeye Senior Macro analyst Darius Dale did a detailed analysis of a favorite bearish indicator - the cyclically-adjusted price-to-earnings ratio or CAPE. The CAPE ratio is a valuation measure defined as the current price divided by the past ten years of inflation-adjusted earnings. The ratio is designed to put into perspective current equity market prices versus market history.
Sure, stocks are expensive. The current CAPE ratio is 29.8; that's in the 96th percentile of all readings (i.e. more expensive than 96% of the data) going back to January 1881. That sure is expensive. An alarmist headline from Business Insider, points out that "Stocks have only been this expensive during the crash of 1929, the tech bubble, and the financial crisis."
But before you go out and sell your Expensive stocks...
Consider that market valuations can get a lot more expensive from here.
As Dale writes in a recent Early Look:
"The top 10 one-year-forward returns of CAPE Ratio readings between the ninth and tenth decile carry a whopping average of +34.8%! That figure drops to +30.2% for the top 20 and +21.3% for the top 50. Over the last 30 years, the average of the top 10 one-year-forward returns of CAPE Ratio readings between the eighth and ninth decile is +31.1%."
Dale asks a simple question: Can you afford to miss a +31% move to the upside in your benchmark?
To underscore his point, since Business Insider noted that stocks have only been more expensive during the Great Depression, the 2000-2001 tech bubble and the 2008 financial crisis, the S&P 500 is up 8.5%. FYI: Over that same period, Biotech stocks are up +17.7% and Energy stocks are down -16.2%.
So remember, you have to understand the prevailing trends of growth and inflation to get the directional macro changes right. With U.S. growth heating up and inflation cooling off, we say a winning recipe is to continue to buy Biotech stocks on pullbacks and short Energy stocks on strength.