Pushing Beyond Index When Looking At Rest Of 2014

Brian Selzer Brian Selzer

OCEAN CITY — The size, style and sectors that worked in 2013 have struggled so far in 2014. With the market seeming to take a bit of a breather, it’s an appropriate time to look at these shifts and consider how we see the trends playing out over the

remainder of the year.

While small caps outperformed large caps in 2013 by 5%, the year-to-date period hasn’t been as kind to them as they have underperformed large caps by almost 7%. Underperformance in the small cap space has been driven by concerns over earnings and elevated valuations relative to history. More extreme valuations in the biotech and technology sectors led to concerns that the whole small cap world was overvalued. In addition, U.S. small caps have been hampered by first-quarter earnings misses in cyclical sectors, due in part to severe weather. We believe the profits will stabilize later in the year as economic

activity recovers. However, we caution that small cap volatility could continue until there is a longer trend in growth of the U.S. economy, since improvements in sales and earnings are very much tied to it.

Style performance has reversed from last year as high-growth equities have started to lag value stocks. Recently, the gap between the performance of large-cap growth and value indexes has grown. The Russell 1000 Index, a proxy for large cap equities, has returned 2.33% this year (as of May 9) but for the growth segment it’s been 1.07% and for the value component 3.65%. While the divergence can be attributed in part to differences in sector weightings, that does not tell the whole story. We believe it also arises from a shift in investor positioning and re-assessment of high-growth earnings expectations.

Fund flow data show U.S. growth funds have suffered $8 billion in outflows this year while value funds have seen $5 billion of inflows. This is the largest shift in investor positioning from growth to value since the end of 2008. However, our U.S. Equity Strategy colleagues at Bank of America Merrill Lynch (BofAML) Global Research note that while the change in investor positioning is significant, the disparity in performance between the styles is not as large as with the style rotations experienced in 2000 and 2007.

We believe investors who continue to search for growth need to be more mindful of reasonable valuations. Growth stock multiples have shrunk recently as market performance has suffered. We see a significant downside risk in richly valued growth stocks, with little to no current earnings but high expectations for the future. Rising real bond yields typically signal to investors expectations of better economic growth and greater availability of growth investments. Higher real bond yields also mean higher discount rates for future earnings growth and therefore a lower present value of future earnings, hurting high-growth stocks.

As concerns over the effect of weather subside, we expect a resumption of the rotation into more cyclical, economically sensitive sectors, such as technology, industrials and energy.

Less macroeconomic uncertainty and fewer signs of economic shocks typically translate into a more favorable environment for cyclical stocks. In looking for opportunities in the value segment, investors should consider more cyclical sectors, an approach consistent with our beyond-the-index investing theme and our focus on TEAM USA (Technology, Energy, Automobiles and Manufacturing). Energy sector performance year-to-date continues to be strong and remains one of our favored cyclical sectors in 2014.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)

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