We do not yet know if the recent rally triggers a new bull market in equities.
But here’s a sure bet: once the new bull market is here, entirely different groups will lead. It will be with the old – think of the FAANGs – and with the new.
To find out which new sectors will be trending, I recently contacted John Linehan of the T. Rowe Price Equity Income Fund PRFDX.
He is a good source of market information as his strategy beats the Russell 1000 Value Index RLV
by more than one percentage point over the past three years. In addition, he manages a lot of money, almost 29 billion dollars. Let’s first see why the FAANG probably won’t lead – because chances are you think they might.
Forget the FAANGs
Don’t think that because Meta Platforms META,
and Tesla TSLA
are best in class in their industries, they will be back on top.
“There’s still this belief that once we get over this economic angst, we’ll get back to the market that we had for the last decade, where growth and technology will do well,” Linehan says.
It probably won’t, he says, for two reasons.
1. Inflation will be much higher for longer, thanks in part to reshoring, which reduces the downward pressure on prices that we have experienced as a result of globalization.
This will result in consistently higher interest rates, which will favor value stocks over growth. Higher interest rates hurt “long life assets” such as technology and FAANG. Much of their income comes in the distant future. This income is worth less today when discounted to the future by higher rates.
2. Competitors have emerged to challenge leading technology companies. It will be a headwind.
Take Netflix. Ten years ago, she owned streaming because she practically invented the concept. Investors might value the company based on subscription growth and ignore profitability. But to date, traditional content providers have reacted aggressively, Linehan notes. DisneyDIS
is now a major competitor, with its Disney+ and Hulu offer.
“It calls into question the competitiveness of Netflix’s business model,” Linehan says.
Tesla now faces challenges from other automakers, threatening its leadership in electric vehicles. Meta faces competition from new entrants including TikTok. Alphabet still dominates online advertising, but the company is more mature. It will therefore be more difficult to grow during a downturn.
Linehan is not negative on all technologies. He thinks Apple AAPL
still has a competitive gap. His fund also owns Qualcomm QCOM
– it was the sixth position at the end of September – because it plays such an important role in connecting devices. This plays on mega trends beyond smartphones, such as smart cars, self-driving and the Internet of Things (IoT).
“Qualcomm has a great collection of companies,” Linehan says. “We like their exposure to many parts of the market that are seeing secular growth. We don’t think the market is pricing them properly.
Qualcomm has a forward price-to-earnings ratio of just under 12, well below the S&P 500 P/E of around 16.
With the new
To find the groups that will lead the next bull market, look among the value sectors, which outperform growth when interest rates are higher. Another reason is that they were left for dead, Linehan says. The discount that value has to growth is greater than it has been nearly 90% of the time over the past 40 years.
Then look for good fundamentals. This brings us to three groups that will likely lead the next bull market.
Here’s a chart from Bank of America that shows finance has been “left for dead.” They are trading well below their historical P/E valuation, and they are also historically cheap relative to the S&P 500.
This discount seems odd, as financials benefit from higher interest rates. They’re probably cheap because so many people are expecting a recession, which can hurt the banks if the loans fail.
But banks are now much better capitalized, less risky and better able to withstand shocks, thanks to the increased capital requirements put in place after the Great Financial Crisis. Also, while Linehan thinks the Fed will push the economy into a moderate recession, he says so many people are expecting a recession, it may already be priced in.
Linehan has a lot of belief in finance as his top position is Wells Fargo WFC.
The bank has historically traded at a premium to other banks, but is now trading at a discount. Wells has a price-to-book ratio of 1.17, compared to 1.55 for JPMorgan Chase JPM,
Wells Fargo is cheap, in part because regulators blocked growth of its asset base following revelations of scandals like creating fake accounts to meet growth targets. But Wells Fargo still has a strong banking franchise. And compliance costs will decline as regulatory requirements dissipate. Linehan’s fund also owns Goldman Sachs GS,
Huntington Bench Sharing HBAN,
State Street STT,
Fifth Third Bancorp FITB
and Morgan Stanley MS.
He also points the finger at the insurance company Chubb CB.
Insurers, considered part of the financial group, benefit from rising rates as they place most of their fleet in bonds. Insurers earn more as their bonds transition into higher-yielding issues. P&C insurers have pricing power again, in part because of the prevalence of weather-related natural disasters.
“Many people worry about the ability of insurance companies to price policies in the context of changing weather conditions, but they forget that there is an increased need for insurance because people worry more potential disasters,” says Linehan.
You might think Energy is a group to avoid because they have performed so well. Despite the strength of the shares, the group still looks cheap.
“Energy was uninventable five years ago when oil prices were low. With oil now around $90 a barrel, these companies are extremely valuable,” Linehan says.
Decarbonization is a threat, but it will take time. “It’s clear that hydrocarbons will be part of the equation for a long time,” he says.
It distinguishes TotalEnergies TTE
because it provides natural gas, which is scarce. He also has a significant position in CF Industries CF
(fourth holding). It makes fertilizer, which requires a lot of natural gas. CF Industries is based in the United States where natural gas is much cheaper than in Europe. This gives it a huge competitive advantage over European producers. Linehan also owns and Exxon Mobil XOM,
Resources EOG EOG
and TRP from TC Energy,
a pipeline company.
“Utes” doesn’t look particularly cheap relative to their history or the S&P 500, according to Bank of America.
But that’s misleading because utilities now have better growth prospects. They are playing on a megatrend: increasing the use of electric vehicles as part of decarbonization.
“Utilities are at the forefront of the energy transition. It will benefit them,” says Linehan. The transition will increase their rate base because it increases the demand for electricity.
The second largest position in his fund is Southern Co. SO.
Based in Georgia, Southern is benefiting from southerly migration and the strength of the southeast economy. It has a nuclear plant that will be commissioned, which will improve its carbon footprint and reduce its costs.
“Southern has generally traded at a premium to the Utilities universe, but currently it’s trading more in line with the Utilities averages, which we believe is unwarranted,” Linehan says.
The fund also holds Sempra Energy SRE.
The San Diego-based utility is playing on power shortages in Europe as it develops a liquid natural gas (LNG) export plant in Texas called Port Arthur LNG.
“It’s intriguing because it’s increasingly clear that the United States will be the supplier of natural gas to the rest of the world,” the fund manager said.
Michael Brush is a columnist for MarketWatch. At the time of publication, it has META, NFLX, GOOGL, TSLA, and QCOM. Brush suggested META, NFLX, GOOGL, TSLA, DIS, AAPL, QCOM, XOM, EOG, WFC, JPM, GS, HBAN, FITB and MS in his newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.
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