How to stay in stocks if the record market has you fearing bubble

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The current bull market has been defined by the fact that nothing can defy it. Threats come and go, but stocks keep setting new records. Among the latest threats: interest rates are rising, which can be bad for stocks, including the big tech companies that have dominated returns in the S&P 500, and some of the biggest names in the market are sounding alarms about stock valuations being so high that a market correction is likely.

But even among the market’s brightest, defiance of the risk-on investment stance is not a stand easily taken. “I think the path of least resistance … is still up,” Mohamed El-Erian, chief economic adviser at Allianz, recently told CNBC. “The technicals supporting this market are strong, but if you’re looking for warning signs there are some warning signs coming out of the fixed-income market.”

Selling this market hasn’t been the right move, at least not for long, for years now. After suffering through a 34% price decline early in 2020, the S&P 500 recouped all that it lost by August 18 and went on to set 20 new closing highs through the end of the year — while enduring twice the average annual count of 1%+ daily volatility, according to data from CFRA.

But reversion to the mean has a history of eventually being right when it comes to stocks, and there are ways to invest in a richly valued market without giving up on it — investment strategies with a focus on sectors and asset classes that have underperformed and can add a form of stock market hedging without necessarily giving up on winners. And there are some big current disconnects in pricing between winners and losers.

A trader works on the floor of the New York Stock Exchange.
Lucas Jackson | Reuters

Over the last three years, the S&P 500 has outperformed the S&P developed international and emerging market indices. The last time those international markets outperformed the U.S. large-cap index was 2017.

Small-caps have underperformed the S&P 500 since the end of 2018.

The price growth gap between S&P 500 Growth and S&P 500 Value was at its highest in history this past August (dating back to the mid 70s) and is currently, even after some stock rotation, as wide as it was in Dec. 1999, before dotcom crash. 

“If you are a believer in reversion to the mean, there is a good possibility it becomes that reversion year,” says Sam Stovall, CFRA chief investment strategist.

That’s a message that comes as fourth quarter 2020 earnings season begins and large-cap stocks that have led the way look a little “exhausted” compared to others as far as earning growth potential as a catalyst for higher stock prices in 2021.

The last red ink from steep 2020 losses caused by the Covid-19 pandemic will finally be put on the books and the market will move past an ugly year, but the S&P 500 looks stretched as far as earnings growth potential, especially the growth stock part of it, compared to other market bets.

The S&P 500’s 12-month price-to-earnings ratio is at a premium of 45% to its 20-year average. CFRA pegs 2021 earnings increase for the S&P 500 Growth component of the index at 13.3% versus 20.1% for its value group.

Equal weights and barbells

This analysis suggests it could be time to do what many financial advisors have recommended with core U.S. market exposure: consider moving away from the market-cap weighted S&P 500 where the gains have been concentrated in growth and into an equal-weight S&P 500 index funds and ETFs, such as the Invesco S&P Equal Weight ETF (RSP). That allows investors worried about a large-cap index now concentrated (as much as 25%) in a handful of mega tech stocks to gain a form of hedging within the index itself with more of the value-oriented stocks and sectors that have not run being greater represented.

“Last year’s losers are those that have not been overpriced and won’t experience as deep of a drop in a pullback many people believe market is ready for. The old adage is let your winners ride and cut losers short, but losers could bounce back quicker or hold up better should we have a correction from overvalued levels,” Stovall said.

Some of 2020’s ugliest sectors have the best potential for earnings growth in 2021.
CFRA

But investors also need to look beyond the S&P 500 for earnings growth. While large cap stocks overall are expected to post a 20% gain in earnings this year, for mid-cap stocks it is 40% and for small-caps, 77%. Overseas, developed markets stocks earnings are expected to rise 40.8%, while emerging markets rise 36.6%.

CFRA research also suggests that what is called the “barbell portfolio” strategy might be in order. You don’t have to sell the biggest winners in the S&P 500, but history says you will do well if you also hold last year’s biggest losers, and you can beat the overall market. Investors who have owned the S&P’s worst sub-sectors from the previous years, or stocks that represent those sectors, have generated market beating growth.

Since 1991, combining the 10 best S&P 500 sub-sectors with the 10 worst groups into the barbell portfolio delivered a compound annual growth rate of 12.6%. In all but three years (2008, 2011, and 2018), the average return for either the top-10 or bottom-10 sub-industries beat the market.

“It has typically been better to ‘let your winners ride’ by building a portfolio of last year’s top-10 S&P 500 sub-industries since they posted a substantially higher average CAGR and frequency of price increase. However, should one worry that last year’s best performers rose too far and that the pounding endured by the 2020 laggards was too tempting to pass up, the barbell portfolio may be a suitable alternative since it has also delivered a market-beating return along with an improved return-for-risk ratio,” Stovall wrote in a recent report.

It is important to remember that if the market drops, everything drops. Investors can’t avoid a risk-off shift in the markets entirely if they stay invested.

“A receding tide drops all boats, but who will recover more quickly? We could see those areas of valuation vacuums the where greatest values remain: international, small-caps and value stocks. When you don’t like anything is when need to own everything,” Stovall said. “”If you’re not committed to one thing that’s when own everything.” 

As fears of a dotcom bubble repeat come into focus, Stovall also noted that in 2000 when large caps were down, both mid and small caps were up. It wasn’t until 2002 that all three segments of the market were simultaneously dragged down.

Thinking in terms of barbells, equal weight S&P 500, and also value, small-caps and international — all the multi-year underperformers — is a way to implement a simple message for investment strategy in 2021: “Now is a time to increase diversification, not narrowly focus on riding the winners in large-cap growth,” Stovall said.

The S&P 500’s best- and worst-performing sub-sectors of 2020, and stocks that are proxies for these sector bets which have outperformed the index as a whole in subsequent years, based on the history of the index since 1991.
CFRA

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