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VOL. 39 | NO. 18 | Friday, May 1, 2015

Pays to be selective in today’s market

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Last week, the Nasdaq, the S&P 500 and the New York Stock Exchange composite indexes all hit new historic highs, bolstered by falling rate hike expectations.

In the market environment of the day, economic softness causing falling revenues and falling prices (see Q1 earnings season) holds less influence than falling interest rates.

Amazingly, since 2009, companies within the S&P 500 increased earnings a cumulative 200 percent and P/E multiples 50 percent, deriving a 250+ percent return for investors.

Meanwhile, revenues across the S&P 500 have only grown 34 percent.

Today, the forward P/E on the S&P 500 at 17.1 exceeds the trailing five-year average of 13.7, the trailing 10-year average of 14.1 and the trailing 15-year average of 16.

With stock valuations vaulted after this historic run, should investors buy this market?

When the forward P/E of the S&P 500 troughed around 11x in 2009, “buying the market,” or “indexing,” made sense as the investment decision was basically binary…either you wanted exposure to the stock market or you didn’t. This was not a period of selection, only a question of participation.

The rapid rise in the US dollar enhanced the indexing trend as foreign capital sought rapid participation equity vehicles.

Last year, as index capital flows ballooned, less than 20 percent of actively managed mutual funds outperformed the benchmark. Investors plowed an incredible $216 billion into the Vanguard complex of index funds in 2014. Vanguard manages over $3 trillion today, up from $2 trillion in 2012. That’s a heck of a lot of a good thing.

However, as the stock market and economic cycle grow grey, operating performance and valuations may require more than binary thought from investors.

For instance, the surge in the dollar that attracted assets into large US multinationals, has also damaged their earnings.

Companies in the S&P 500 with more than 50 percent of their sales within the US have grown revenues 0 percent compared with -11.2 percent for those with 50 percent outside the US, according to Factset.

This disparity in operating performance has also created a disparity in shareholder returns as domestically oriented big caps have handily outperformed their more venturesome peers.

Lofty composite valuations paired with wide divergences in corporate operating performance provide opportunity for active stock pickers.

The Vanguard 500 index, which outperformed more than 80 percent of its large cap peers in 2014, has only outperformed 45 percent of its peers through the first quarter of 2015. Interestingly, passive management tends to outperform significantly towards the tail end of a bull cycle.

If you believe in history and mean reversion, which we do, now may be the time to increase scrutiny and selectivity.

Bottom Line: After six years of uninterrupted gains, broad-based indices are no longer cheap. Additionally, the surge in the dollar has created stark financial divergences between US corporate earnings performance and US corporate share performance.

Active stock pickers should hold advantage in this more heterogeneous environment. So would we “buy the market”?

No. At this point it pays to be in, but it also pays to be selective.

David Waddell is president and CEO of Memphis-based Waddell & Associates.

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