U.S. Equities: Begin The Process Of “Leaning In” – KKR

U.S. Equities: Begin The Process Of “Leaning In” – KKR  H/ T Mebane Faber

 

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U.S. Equities: Begin The Process Of “Leaning In”

We are adding two percent to our U.S. Equity position, lifting our weighting to 22% from 20% and a benchmark of 20%. This increase now takes our overall Global Equity allocation to above benchmark for the first time this year, with a notable overweight to developed markets relative to an underweight in emerging markets. See the following pages for specific details, but we fund this increase in U.S. Equities by reducing the cash balance we elected to build up in January 2015. From a cyclical perspective, we see negative sentiment, decent – albeit unspectacular – EPS growth, and reasonable valuations as signals to “Lean In” to certain parts of the U.S. market. Probably more important, though, is the positive secular case we now see unfolding for the United States. Indeed, the long-term outlook for the U.S. consumer has improved materially in recent quarters, and we now see more gains ahead, particularly around household formation. Meanwhile, Corporate America is increasingly leveraging its “Made in America” innovation across a variety of sectors, including Healthcare, Technology, and Energy Services, to distance itself from its global peers. Against this constructive macro backdrop, our allocation framework now argues for an increased weighting on both a short-term and long-term basis to the United States.

“The biggest risk is not taking any risk… In a world that is changing really quickly, the only strategy that is guaranteed to fail is not taking risks.” Mark Zuckerberg, American computer programmer and internet entrepreneur, founder of Facebook

In January 2015 when we decided to raise our Cash allocation, reduce our overweight to Global Equities for the first time since 2011, and tilt the portfolio more defensively (see  Getting Closer to Home), we did not foresee something akin to what happened on Monday, August 24th, when the market essentially went into a technical free fall, as VIX spiked to 40.7 from 13.0 just seven days prior. However, after six straight up years in the U.S. equity market amid near record low volatility, we did have enough good sense to know that it was not the time to stretch for equity returns – despite an improving outlook for the U.S. economy relative to its global peers, China in particular.

Today, we see the world differently. We no longer believe investors should get “Closer to Home.” Rather, with the global capital markets quite unsettled, we want to begin the process of “Leaning In” by allocating more incremental capital back towards risk assets, particularly in the U.S. To this end, we are making the following two changes to our target asset allocation (see Exhibit 3 for full allocation details):

• We are reducing Cash to 1% from 3% versus a benchmark of 2%. With prices down and volatility up, we now feel compelled to start to spend some of the “rainy day” funds we husbanded back in January. Implicit in our decision is our view that, while the equity cycle is mature, it is not yet over. Further details below.
• We use our cash proceeds to boost our Global Equity allocation to overweight from equal weight by raising our U.S. Equity allocation to a 22% weighting, compared to 20% previously and a benchmark weight of 20%. We retain our one percent overweight to Asia (with focus on Japan) and our two percent overweight to Europe, offset by our two percent underweight to Latin America, Brazil in particular.

We note three tactical considerations that we think are worthy of investor attention as one considers bolstering his or her equity position in the United States at this point in the cycle. They are as follows:

• First, as we describe below in great detail, our proprietary KKR Equity Capitulation Index reflects our view that the U.S. equity market is now clearly oversold. In the past, particularly around the sovereign crises of 1998 and 2011, the indicator gave important buy signals when it spiked to the levels the market just recently experienced.
• Second, 67% of the U.S. earnings this year will come from Consumer Discretionary, Financials, Technology, and Healthcare. We generally feel good about the sturdiness of these earnings streams as we head into 2016, a belief that is confirmed by our proprietary KKR Earnings Growth Leading Indicator (Exhibit 9).
• Third, valuations are now reasonable to attractive in many sectors after the recent sell-off (something we were not saying back in January). Specifically, the S&P 500 was trading at 16.4x trailing earnings at the end of August 2015, compared to 17.3x in early January 2015, a peak this year of 17.9x in May 2015, and a long-term average of 15.7x since 1965.

 

While we expect there to be plenty of debate around whether to add to U.S. Equities at current valuations, at this point in the cycle, we think that the long-term outlook for the United States has become much less controversial, particularly relative to its global comps. Indeed, at a time when the China Growth Miracle that defined the 2000-2010 period is waning (see China’s Rebalancing Effort: Will It Be Enough), we see the U.S. gaining increasing stature as an investment destination of choice. Consistent with this view, we see five large scale investment opportunities that we think will garner an increasing proportion of capital flows and investor attention over the next few years:

1. U.S. household formation is breaking out; invest behind this development. Key sectors that should prosper include housing, multi-family rental, home repair, etc. (See March 2012 Insights note U.S. Housing: A Changing Dynamic). Importantly, as we detail below (Exhibit 49), we recently again revised upward our housing start forecast as part of this deep-dive on U.S. fundamental growth drivers.
2. While we do not see a major shift in consumer preferences towards higher-end products, we do expect more consumer spending in many areas, including recreation, beauty, and wellness. As we detail below, consumer “experiences” are taking precedence over “things” – a trend we expect to continue at an increased pace. Also, given that we look for little improvement in productivity, we expect strong employment growth trends to continue in the United States. If we are right, this trend is constructive for broadening spending patterns in the U.S.
3. U.S. non-cyclical, growth stocks, particularly in Healthcare and Technology, should continue to appreciate. We acknowledge that near-term valuations are stretched in certain instances, but we like big market opportunities like diabetes/insulin delivery, immuno-oncology, and cyber security. Given its proximity to Mexico and Canada, we also think that the United States is reestablishing itself as a compelling place for re-shoring initiatives. We do not see a true “manufacturing renaissance,” but believe there are some noteworthy tailwinds that now warrant investor attention.
4. We expect U.S. Financial stocks to perform well too. In particular, we favor domestic banks, insurance companies, and card companies that should benefit from better credit conditions, loan growth, and lower legal costs. Consistent with this view, mortgage credit and asset-based lending should perform better than current expectations, particularly if we are right that long-term rates remain low. Importantly, though, we focus on financial companies with aggressive capital management programs because we do not expect to be bailed out by higher short-term rates surprising on the upside in late 2015/early 2016 (Exhibit 10).
5. Our “value” idea for the U.S. equity market centers on the Energy sector, which is suffering from an overhang of excess capacity and capital. With valuations down meaningfully, however, we think that now is the time to begin the search for long-term winners amid the rubble. In particular, it appears that in certain instances the market is not discerning properly between low-cost and high-cost producers as well as between recurring revenue infrastructure stories and more speculative exploration and production names. Also, as we describe below in more detail, we think that convertible securities in the energy arena could at times be a more efficient way to play this “value” investment theme in Energy.

See full PDF below.