US equity indices continue to reach new highs on a regular basis but this does not mean all is well in the overall market.
Following the sharp rebound from the lows of February 2016, returns have been increasingly led by a narrow group of stocks.
Investors have gravitated to parts of the technology and internet sectors as sources of steady growth and to the consumer sector as a source of consistency and yield. These areas are becoming over-owned and rising complacency is becoming apparent as strong passive flows have helped to push up prices and, in some cases, valuations.
The crowding has been increased by a rotation out of cyclical sectors that had been in favor since the presidential election. President Donald Trump came into office promising a pro-growth agenda of tax reform, reduced corporate regulation and increased fiscal spending in areas such as infrastructure.
Optimism for these programmes caused stocks in the financials, industrials and materials sectors to outperform into the early part of this year. But the failure of the Republican-controlled US Congress to muster a healthcare bill to replace Obamacare, and the subsequent investigation of the Trump administration’s relationship with Russia, has pushed out the likelihood of meaningful spending legislation and tax reform being passed into 2018 – if not later.
Rising interest rates was another factor behind the boost to financials in the latter half of 2016 and into this year but despite the US Federal Reserve gradually tightening monetary policy, raising short-term rates twice so far in 2017 with plans for one additional increase this year, mixed signals from the US economy have made significant increases an unlikely outcome in the near future.
With cyclicals losing these key catalysts, investment flows have returned to technology and more income-oriented sectors. Some consumer staples stocks now trade at price-to-earnings multiples two to three times those of stocks in the healthcare and energy sectors.
A dovish stance from the Fed provides another linchpin of support for dividend-paying consumer stocks, which tend to underperform when rates rise sharply, as bonds become a more attractive income source.
The economy grew at a rate of just 1.2 per cent in the first quarter and hiring has cooled after a strong start to the year, with an average of 120,000 jobs created per month over the last three months (although the US unemployment rate of 4.3 per cent is at its lowest level in 16 years).
In addition to boosting stock values, steady inflows into passive exchange traded funds and index funds has contributed to unusually low market volatility. Judged by the CBOE Volatility Index or Vix, equity volatility is at its lowest levels since 1993.
We are concerned that too many investors equate passive with low risk and such complacency could leave the overall market and particularly certain sectors and sub-sectors vulnerable to a correction.
At the same time, other areas, like therapeutics companies in healthcare and parts of the media and energy sectors, remain at historically low valuation levels, particularly relative to growth opportunities.
Based on current trends, the crowded trades in certain areas of the US equity market may continue. But the risk of failure for these trades is also rising. High active share managers delivering non-correlated return streams can provide diversification and alpha for investors heavily exposed to passive strategies.
Evan Bauman is manager of the Legg Mason ClearBridge US Aggressive Growth fund