US Equities: Staying Afloat in Choppy Markets

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At first glance, U.S. equities seem to be turning a corner: They’ve rebounded from their February lows, bolstered by signs that China’s economy is stabilizing, dovish signals from the Federal Reserve, and a recovery in oil prices. And the majority of U.S. companies have beat first-quarter earnings and sales expectations. But that’s all in the past. Looking forward, Credit Suisse believes that several challenges will lead to choppy market conditions for the remainder of the year.   Investors pulled nearly $10 billion from U.S. equity funds in March, marking the reversal of a trend that had been improving since the start of the year. (January and February outflows totaled just over $5 billion and just under $1 billion, respectively.) Large-cap equity funds actually started the year with inflows: Investors directed more than $1 billion in January and again in February to large-cap funds. But in March, it all changed: $8 billion was withdrawn from large-cap funds during the month.   And yet, U.S. stocks still aren’t cheap. Credit Suisse’s multi-factor S&P 500 valuation model indicates that stocks are trading 1.38 standard deviations above their 30-year average. Historically, valuations near that level have portended returns in the low single digits over the following 12 months. Growth stocks appear especially vulnerable: Though the Federal Reserve has held its fire in recent months, Credit Suisse believes the December rate hike set off a rotation out of growth stocks among investors who believe the stocks became inflated during the zero-bound years. Credit Suisse economists believe the central bank will raise rates again in September.   Another red flag: Buyback and dividend activity is stalling. Buyback announcements peaked in late 2014 and early 2015 for mid-cap and large-cap stocks. Quarterly buyback activity rose from a post-financial crisis trough of below $40 billion to some $160 billion in the quarter ended March 2014, but it has hovered between $140 billion and $160 billion since then. The percentage of large-cap companies paying dividends also rose since the financial crisis, from a low below 75 percent to a high of 85 percent. But it, too, has barely budged since September 2013. Mid-cap and small-cap dividend payers have seen similar trends. Credit Suisse analysts suggest these are signs that a deceleration in buybacks and dividends could be in the offing. While M&A activity ticked up recently, with more companies in all three size segments seeking acquisitions in the first quarter of 2016 than in the previous quarter, both the number and value of deals remain well below 2015 highs.       If a pullback does occur, there’s a simple explanation for it: Companies have less money. Levels of corporate cash, though still high from a historical perspective, have slipped relative to assets in recent years, while debt levels have steadily increased since the financial crisis. As such, companies will likely be more selective about how they put cash to work going forward, according to Credit Suisse U.S. equity research strategists. A slowdown in buybacks could be a drag on mid- and large-cap stocks in particular, as both have relied on stock purchases to boost share prices and earnings per share.   The health of the global economy will also shape stock performance this year. Growth in global industrial production continues to be sluggish, and while Credit Suisse economists expect it to trough within the next two months, they also expect it to remain below its long-term trend for some time after that. That doesn’t bode well for stocks, either.   Despite the challenges on the horizon, there are some pockets of the U.S. market with the capacity to outperform in the coming months. If history is any guide, the continued weakness in global IP should prove less damaging to both small-cap and value stocks. Of the three major global IP slumps since the 1980s, small caps outperformed large caps during two periods, while value stocks bested growth stocks during all three downturns. Certain sectors also become more attractive in times of weak global industrial production, including small- and large-cap banks, media, consumer services, consumer durables and apparel, retail, and transportation names.   Small caps have a few additional advantages. While they’re expensive relative to their 30-year average – Credit Suisse’s multi-factor Russell 2000 valuation model indicates that small caps are trading 0.64 standard deviations above trend – they’re also much cheaper than their large-cap peers. Investors are betting on value over growth, though: Small-cap value funds are the only group of U.S. stocks to record year-to-date inflows – about $1 billion – while small-cap growth funds have experienced some $2.5 billion in outflows so far this year.