Go For Growth

8/22/2016


While we like to pick stocks on their individual merits rather than big-picture speculations, we see two broad themes capable of extending the 90-month bull market:

• Stocks are the new bonds. Under this scenario, money continues to migrate out of the bond market in search of higher yields in the stock market, and the most bond-like stocks with the lowest volatility remain in favor.

• Earnings growth is set to revive. Under this scenario, investors rotate toward stocks supported by operating momentum and solid profit-growth prospects, exiting bond-like stocks in consumer staples and utilities.

Of course, these scenarios may not be so mutually exclusive. If bond yields remain low even as profit growth accelerates, both bond-like stocks and growth-oriented stocks could thrive. But, because of today's highly unusual valuations, growth-oriented stocks offer a vastly superior tradeoff of risk and reward.

Not only do the least-volatile stocks trade at the highest absolute price/earnings ratios and the highest P/Es relative to their long-term norms, they also have the lowest expected profit-growth rates.

Among members of the broad S&P 1500 Index, the least-volatile one-fifth of stocks based on standard deviation trades at an average trailing P/E of 25, the highest since our data begin in 1994 and more than 30% above the 22-year norm. The other four quintiles all trade at P/Es of 21 to 23.5 — none more than 11% above their long-term norm.

The least-volatile quintile earns an average Quadrix® Value score of 44, below its long-term norm of 60. The other four quintiles earn average Value scores of 54 or higher. Partly as a result, the least-volatile quintile is the only one with an Overall Quadrix score below its long-term norm.

What to do now

Be wary of funds that focus on low-volatility stocks. While it makes sense to look for opportunities among lower-risk stocks, emphasize those with reasonable valuations and solid profit-growth prospects. Top picks include Comcast ($68; CMCSa), CVS Health ($98; CVS), and Kroger ($32; KR).

Look for buying opportunities among bona fide growers. Chasing richly valued story stocks is always dangerous, but many growth-at-a-good-price names look attractive after a year of poor relative returns. Among all Quadrix factors, PEG ratio (current-year P/E divided by the expected long-term profit growth rate) has been among the worst performers over the past year.

Reversion to the mean is a powerful force on Wall Street, and we think low-PEG stocks are primed to outperform if investors gain some confidence in the outlook for profit growth. Centene ($68; CNC), Citrix Systems ($87; CTXS), D.R. Horton ($32; DHI), LKQ ($35; LKQ), and Owens Corning ($53; OC) rank among the cheapest 30% of U.S.-traded stocks based on PEG,with above-average expected long-term growth rates.

LOW-RISK STOCKS EARN WORST QUADRIX SCORES
Low-volatility stocks have vastly outperformed over the past year, dropping their average Quadrix Value scores near the lowest levels since the S&P 1500's inception in 1994. Average Overall scores for low-volatility stocks are also near 22-year lows.
Quintiles By Standard Deviation
---------------------- Average Quadrix Overall Score ----------------------
Least
Volatile
Second
Quintile
Third
Quintile
Fourth
Quintile
Most
Volatile
Recent Overall score
54
62
65
60
52
Norm since 1994
59
61
60
59
51
Recent as % of norm
90
101
108
102
102
% of mos. since '94
lower than recent
9
57
93
65
53
Quintiles By Standard Deviation
---------------------- Average Quadrix Value Score ----------------------
Least
Volatile
Second
Quintile
Third
Quintile
Fourth
Quintile
Most
Volatile
Recent Value score
44
54
60
59
57
Norm since 1994
60
59
60
57
49
Recent as % of norm
74
93
101
104
115
% of mos. since '94
lower than recent
3
29
52
85
90

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