INDEPENDENT INSIGHTS Market insights from an independent perspective


November 23, 2020

Kevin Karpuk CFA

"Kites rise highest against the wind, not with it." Winston Churchill
The “V” and the “W” both have been used to describe the type of economic recovery that can be expected coming out of a recession. The V, the most hopeful, is a drop followed by a quick recovery. The W is a recovery followed by another downdraft, but this pandemic has brought a new letter into the economic lexicon: the “K”. In a K-shaped economy, some areas flourish while others languish. Technology, for example, was in high demand as companies had to outfit their employees to work from home. In the same vein, residential real estate has done well when combining ultra-low interest rates with a desire for people to leave large cities. They are the upper portion of the K. The lower portion can be thought of as financials and commercial real estate which both have seen headwinds from the pandemic. There is plenty to Google on the K-shaped economy we are in now, but what does the future hold?

Well, the current situation could continue for some period of time, but at some point, a vaccine (or multiple vaccines) will be widely available, and we will return to some sense of normal we enjoyed before the virus. What then? Perhaps the proponents of the K are on to something but have not projected into the future. Could we see a Kite market where growth stocks continue to move higher, albeit at a more moderate pace, and value stocks lead the market by closing the gap that the pandemic created?
If you read a recent Independent Insights, you will remember that our outlook on technology stocks is that “trees can’t grow to the sky”, but why could value stocks rebound once a vaccine becomes available? Economic recovery, valuations, and dividends. What you will read is highly dependent on an effective vaccine and rollout thereof. If either piece falls short, then the “deep dark winter” that some fear could come into place. We purposely did not put an x or y-axis on the graphic above because the remaining uncertainty makes guessing the time or magnitude of either quite difficult.

Economic recovery is the linchpin for value to show the recovery that is depicted above. 40% of the Russell 1000 Value is in financials, industrials, materials, and energy with about half of that weighting coming from financial stocks. A reopening obviously helps the latter three sectors which are directly correlated to the economy, but financials might be the most interesting piece of the equation. Stocks such as JPMorgan Chase & Co. (which has lost about 17% of its value so far this year as of the writing of this article) can benefit from three different levers of recovery. First, economic activity spurs loan growth. If companies
are more certain that the future is brighter than the present, they will borrow to fund growth. Second, financial companies have put billions of dollars into reserves for loan losses. If the banks have overestimated those losses, these reserves can become future profits. Finally, a rebound in the economy will likely cause the interest rate yield curve to steepen (longer rates will move higher more quickly than shorter interest rates.) When you are in the business of borrowing overnight and lending long-term (deposits versus mortgages, for example) steeper yield curves are profit centers.

The current price/earnings ratio on the Russell 1000 Growth is about 40x earnings. On the value index, the same metric is 17x earnings. These are based on profits over the past year. Growth proponents can jump up and down screaming that future expected earnings growth will accrete mostly to technology stocks rather than old economy equities. That could be true, but the high wire act of meeting those expectations can be tricky. From the value investor’s standpoint, it is hard to fall off the floor – unless of course, you have a basement.

If one believes that future stock appreciation will be muted, then dividends could become an increasing factor in returns. Growth stocks have historically paid paltry dividends compared to value issues. In large caps, value stocks currently pay about 4.5 times the dividends that growth stocks do. It has been years since dividends have been highly valued by market participants. Could lower return prospects and the potential for changes that even out the tax rates on income versus capital gains change that?

While we do believe that value and growth will converge – historically, they always have – a kite will not fly on a calm day. There is likely to be volatility and fits and starts to this coming together. During that time, investors should remain calmly at the helm. The kite may twist in unexpected directions as gusts blow across the sky, but subtle adjustments from the ground can help it stay aloft.

Kevin Karpuk, CFA Chief Investment Officer

Kevin is Cornerstone’s Chief Investment Officer and is involved with the firm’s Investment Policy and Strategic Planning committees. Kevin joined the company in 2000 after graduating from Lehigh University with a B.S. and M.S. in Economics and earned his CFA charter in 2005. Kevin and his wife Kat support many charitable causes and have established a donor advised fund to propagate their philanthropic interests. They live in Bethlehem with their two cats: Zola and Charlyne, enjoy woodworking, gardening, reading and travel. Kevin is the proud uncle to many nieces and nephews and loves spending time with and spoiling them.

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