Because the market is a forward-discounting mechanism, it's not unusual for it to have led the economic recovery over the last four years. Today, I believe the market has already discounted a decent economy over the intermediate term and is approximately fairly valued.
But that's not the whole story.
Awaiting top-line growth
For markets to sustain current levels at this pivotal point, the elusive handoff to top-line growth must happen. So far in the recovery, earnings growth has come largely from efficiency gains and share buybacks. Capital expenditure (capex) also remains depressed in eight of 10 economic sectors.1
So far, corporate management teams' lack of confidence in the duration of the recovery and the stability of their end markets has held capex back. The uncertainty of the path of long-term interest rates has contributed to the inability of management teams to project long-term returns on capital and on large, long-term projects.
Weak growth, but high returns and high reinvestment risk
Focusing on the risk-reward profile
Where are we in the current market cycle?
Let me put the answer in the context of our investment strategy, which focuses on three key elements over a full market cycle — appreciation, income and preservation. While we're still finding attractive "appreciation" investments, they were more plentiful earlier in the current cycle. This indicates the need to be very mindful of income and preservation and to increase focus on the risk-reward profile of our investments.
Today we see unattractive risk-reward profiles in more cyclical businesses. Much of our research focuses on "normalized earnings power"— what a company can earn across a full market cycle. We're well past the early stages of this cycle, so it's important to avoid paying for cyclically peak earnings or margins. But that's fairly difficult now because US companies have efficiently managed their costs and balance sheets in recent years, leading to 30-year highs in operating margins.1
Overall, our analysis of cyclicals leads to less confidence in the durability of their earnings profiles, particularly given recent weakness in emerging markets such as China as the government seeks to restrain capital liquidity.
Declining incremental margins given tepid revenue growth and difficult cost cut comparisons
Valuations evolving across dividend payers
We saw a sharp correction in May and June in some of the highest-yielding sectors. For example, some of the sectors perceived to be more interest rate sensitive, such as the utilities sector, saw retracement as investors discounted the end of quantitative easing and associated purchases of the long-end of the yield curve. Many of these companies were trading at 15x to 17x prior to the correction. While there's some difference between regulated and diversified utilities, overall valuations are currently in the 12x to 14x range — only one multiple higher than the long-term average. So there are focused opportunities across equities, even in high-yielding sectors such as utilities.1
However, we are finding most opportunities today are in companies that generate stable levels of high free cash flow, such as some of our investments in consumer staples. These firms have:
- Historically outperformed across the cycle, just not during the first phase of market recovery.
- Earnings profiles that are much more realistic two years out — their net operating profit margins are below peak levels, versus peak margins of many cyclical business. We believe valuations in the range of 14x to 16x are attractive at this point in the cycle.
We are also constructive on the outlook for dividend growth. Companies remain in great shape financially, the market's dividend payout ratio is low versus history,1 and a greater percentage of management teams receive the dividends on restricted stock, rather than options. So companies have the ability to raise payouts, and managements have incentive to give themselves a raise.
Companies have the potential to grow their dividends significantly
At this pivotal point in the market cycle, investors need to:
- Focus on their highest-conviction investments.
- Be mindful of downside risk.
- Put a premium on asset liquidity. Investors often underestimate its value in good times — liquidity is there least when you need it most.
Forward-discounting mechanism refers to the premise that the stock market essentially discounts, or takes into consideration, all available information and present and potential future events. When unexpected developments occur, the market discounts this new information very rapidly.
Dividend payout ratio represents dividends that are paid out by all of the companies within the S&P 500 Index.
There can be no guarantee or assurance that companies will declare dividends in the future or that if declared, they will remain at current levels or increase over time. In general, stock and other equity securities values fluctuate in response to activities specific to the company as well as general market, economic and political conditions. To the extent a strategy invests a greater amount in any one sector or industry, there is increased risk to the fund if conditions adversely affect that sector or industry.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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