- US stocks delivered outsized returns with low volatility in 2017, as earnings rose.
- There is evidence that stocks are in the late innings of a market cycle, so it makes sense to pay attention to valuations.
- Financials and energy may hold opportunities.
If the 9-year bull market were a baseball game, one might wonder if we are now in the late innings. That’s the view of 4 veteran Fidelity stock fund managers as we turn into 2018. They don’t see a downturn around the corner. But with stock valuations looking a bit stretched, they think finding great companies at "a good value" is getting trickier. Here they share their investment approaches—and where they are scouting for opportunities—including financials and energy stocks.
US stocks are expensive, but supported by earnings
Geoff Stein, Fidelity® Stock Selector All Cap Fund
Stocks rallied sharply in 2017, fueled by improved economic growth, low inflation, the gradual pace of the Federal Reserve’s interest rate increases, and perhaps most importantly, a strong recovery in corporate earnings.
But stock performance has actually outpaced gains in earnings, and as a result, US equity valuations appear stretched as we begin 2018—for example, the S&P 500’s price-earnings ratio is well above longer-term historical averages.
Does that mean investors have created a stock bubble? I don’t think so. Various indicators suggest we are far from peak optimism on stocks. Investors pulled roughly a net $36 billion out of US stock mutual funds and stock exchange-traded funds in the third quarter, according to data from EPFR Global. From a sentiment perspective, this suggests at least some persistent skepticism toward stocks, which I view as positive because it suggests a lack of euphoria among investors. It would be more worrisome to me if we were seeing the kind of stock market exuberance we saw during the dot-com boom in the late 1990s or leading up to the 2007–08 global financial crisis.
All told, I think the stock market environment looks supportive, at least for now.
The Fidelity® Stock Selector All Cap Fund maintains a philosophy of holding sector weightings fairly close to those of the US stock market index. The fund’s largest absolute sector position remains information technology, which is also the largest sector within the S&P 500.
Looking ahead into 2018, I am keeping a close eye on the energy sector, where the ability of US exploration and production (E&P) companies to grow oil production—at half the price of oil from just a few years ago—remains a competitive advantage for these firms. Many of these companies also continue to benefit from strategic land ownership near fertile basins, from improving efficiency and productivity of wells, and from maintaining little to no debt.
My energy team thinks the market has been valuing E&P companies as if oil prices will remain low perpetually, and also as if these companies will not achieve any production growth going forward. We have different views, and see many opportunities in the current market environment.
Cautious on US in 2018, but value in retail and Japan
Joel Tillinghast, Fidelity® Low-Priced Stock Fund
I’m abundantly cautious about 2018. Interest rates are low, and it’s far easier for them to move up than down. If they go up enough, I think it could put a lid on the stock market this year.
Also, valuations are high, in my view. Today there are fewer US stocks with low price-earnings (PE) ratios than during the tech bubble of the late 1990s—that’s surprising to me and, unfortunately, low valuations are where I shop for stocks.
Within the US, I expect to remain focused on what I believe are resilient companies with strong balance sheets and skilled, honest executives. Often, the best clues about a management team’s integrity are found in the company’s accounting practices. If a company is using aggressive accounting principles, they are probably practicing risky behavior in other areas. So, aggressive accounting is a red flag for me.
I also continue to favor straightforward businesses that I can easily understand. By comparison, there is a lot of interest today in companies investing in autonomous vehicles. While the prospect of a robot chauffeur driving me around does sound exciting, I personally can’t forecast how that industry will play out, and further, which companies are going to be the long-term beneficiaries. The stocks I invest in tend to be duller. They don’t satisfy people’s appetite for social approval. They often have flaws and they don’t have any obvious catalysts. As a result, they tend to have low valuations.
But often, these companies do something that many customers find uniquely valuable, and I believe their businesses are less likely to be disrupted, no matter how the world turns out.
In my experience, the greatest returns and the greatest disasters come from investing in highly uncertain situations. These are relatively good times in the United States, so now is probably not a promising time for deeply uncertain investments. On the contrary, I am most interested in the relative certainty offered by companies that many characterize as “Steady Eddies,” particularly in the health care, software, and branded retail sectors where the stock prices may not reflect the companies’ intrinsic value.
Retail, of course, is a highly controversial area of investment, as a lot of disruption is occurring. However, I have emphasized my interest in this area of the market recently, because the stocks are priced fairly low on a P/E basis.
I have focused a good portion of my research on Japan, where I have continued to find many good, growing companies with low valuations that are just being ignored. In particular, I think Japanese small-caps have remained the outstanding anomaly in global equity markets. My interest in Japanese small-caps is greatest where I believe businesses are offering something special to consumers, where there are growth opportunities, and where management is vigorous and entrepreneurial.
Given the expected uncertainty and potential volatility in the coming year, I think avoiding high-priced mistakes and management teams that lack integrity—2 things that owners of an entire market index of companies cannot easily avoid—may prove helpful.
High-priced growth stocks seem risky
As I look forward to 2018, I am concerned that the market environment continues to favor high-priced growth stocks, especially a narrow slice of what I consider increasingly expensive technology and consumer discretionary companies.
In my view, investors have crowded into a relatively small handful of fast-growing companies. These include highly profitable businesses such as social media platform Facebook, as well as competitively dominant firms with less-robust balance sheets, including streaming entertainment company Netflix, e-commerce giant Amazon, and electric automobile maker Tesla.
I consider each a good business, some better than others. The problem I see is that their stocks have been trading at massive premiums that I don’t believe reflect their true prospects for future earnings. As of November 30, 2017, the Fidelity Large Cap Stock Fund, didn't hold Netflix, Amazon, and Tesla, and only held 0.24% of assets in Facebook.
In the case of a financially strong company like Facebook, it’s done a phenomenal job taking market share. But investors already appear to have priced in the fact that future growth will continue at the same pace as past growth—an unlikely event as the law of large numbers starts to kick in. I’d put Amazon and Tesla in a different category than Facebook—neither generates a lot of earnings or cash flow, and their financial situations tend to be less certain.
This doesn’t necessarily mean that the stock market as a whole cannot continue to move higher, or that I can’t find good values. However, I do think the fact that such a narrow slice of the market has driven much of the S&P 500’s gains poses a growing risk and headwind for gains in the coming year.
Entering the last few months of 2017, the Large Cap Fund was overweight in financials, with Citigroup, Bank of America, and JPMorgan Chase all among the fund’s largest positions as of November 30, 2017. I believe this sector may continue to benefit from higher interest rates in 2018, which should create more profitable lending conditions.
The fund was also overweight in energy as of November 30, 2017, based on my view that the sector’s down cycle is a function of excess supply and not a demand issue, as global demand has been steadily increasing. Although supply has returned to the market over the short term—due to a combination of increased production from US shale producers and the easy availability of capital via debt and equity markets—I’m expecting supply growth to moderate over the long term as capital becomes more expensive and less available to marginal energy producers.
Conversely, our largest underweights (as of November 30, 2017) were in consumer discretionary and information technology. These 2 sectors fit my theme of avoiding or limiting exposure to a handful of fast-growing, high-valued companies offering what I believe have poor risk/reward trade-offs.
Be flexible in 2018
John Roth, Fidelity® Mid Cap Stock Fund
It has been 9 years since the market bottomed during the financial crisis, which is historically on the long side for a bull market. Overall, margin expansion and earnings growth have continued to be anemic, and multiple expansion has been the more significant driver of performance for the past several years. Additionally, most stocks and asset classes now look expensive to me, relative to their historical valuations.
I think this is sufficient evidence supporting the view that we are in the later innings of a market cycle. Also, volatility appears to have begun returning to equity markets. Looking ahead to the rest of 2018, I think it’s important to remain flexible in regard to positioning.
I think it's particularly important to be diligent in monitoring fundamentals and identifying valuation risk. However, every cycle is different, and existing conditions matter. I have studied a lot of models and correlation studies that use the past to predict the future. They are often wrong, because the models mistake correlation for causality.
While volatility is unpleasant to experience, it is not risk per se, despite what the academics and risk models say. I believe risk to be the permanent loss of capital, and that volatility simply creates good opportunities to buy or sell at potentially great prices. I will try to exploit that in the coming year.
As 2017 came to a close, I was underweight in the information technology and industrials sectors, and I have been seeking to avoid particular individual positions where I have valuation concerns. Conversely, I have been overweight in health care, financials, and energy, although I have reduced my fund’s overweighting in the energy sector. In addition, I held a fairly significant cash position, as I became more sensitive to valuations and aimed to be flexible in case we hit turbulence.
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