Clearbridge Investments published its third quarter commentary. The prevailing theme of the commentary is that we are on the cusp of a shift from growth and momentum outperformance to value investing. The winner of the current cycle, S&P 500 stocks, will perform poorly in the coming cycle and value stocks will outperform. Clearbridge mentions American International Group Inc. (NYSE:AIG) and Biogen Inc. (NASDAQ:BIIB) as compelling investment ideas. American International Group Inc. (NYSE:AIG) shares lost more than 23% so far in October and Biogen Inc. (NASDAQ:BIIB) lost 15%. So, if you agree with Clearbridge, you can buy both stocks at much lower prices than what Clearbridge paid for them. Here is what they said about the market environment and these two stocks:
“Market conditions are changing. The continued rise in interest rates suggests we are in the early stages of a bond bear market, which could intensify as central banks withdraw liquidity. The receding tide of liquidity will start to reveal more rocks beyond what has been exposed in emerging markets so far, and the value of a value discipline will be in avoiding the biggest capital-destroying rocks. If a rock emerges on the crowded shore of U.S. momentum, it could result in a major liquidity challenge, as momentum is often most intense on the downside as a crowded trade reverses.
So investors are facing a large potential trade-off right now: continue to bet on the current dominance of momentum and the S&P 500, or bet on change and take an active value bet in names with attractive value and optionality, but with negative momentum.
If you make the first choice, you will enjoy the comfort of being aligned with the prevailing market chorus that is plowing capital into U.S. momentum names and the S&P 500. If you want to minimize current relative performance discomfort, you must fully embrace this crowded choice by going passive, which means taking an active bet on momentum. But again, cycles are cycles. If history is not violated, as the overwhelming winner of the current cycle, passive S&P 500 returns should be relatively poor over the next market cycle. The more immediate risk is that, so far, we have only witnessed historic levels of passive and momentum buying within U.S. stocks. We have never seen this amount of crowded capital try to sell. It seems logical that the scale of the buying helped drive the shift in market dynamics we have witnessed since early 2017, and that a reversal on the sell side will cause an equal but opposite dynamic.
We think we are observing a change in markets that could trigger a reversal in the market cycle. For one, a continued rise in rates that ultimately normalizes the term premium would push the 10-year Treasury to roughly 5%. The current market hegemony would be severely challenged by this shift, and despite very few cracks in U.S. markets, we believe it is underway. Why?
We are currently witnessing a massive shift in U.S. dollar liquidity as monetary and fiscal policy in the U.S. have shifted. Despite an extremely polarized political system, populism is uniting both extremes in debt-financed fiscal expansion that is daring the term premium to normalize. In effect, populism demands an inflationary response, and when combined with record-tight labor markets, it seems very likely inflation metrics will continue to drift above Fed targets of 2%.
At the same time, trade policy is also inflationary, as it is making global supply chains, which had exported global deflation around the world, much less efficient by taxing them directly. This structural reversal is raising input costs and will require increased capital investment to localize some production capacity.
The inflationary impulse from these massive nonmonetary shifts is forcing U.S. monetary policy to tighten, with the resulting shift in global liquidity squeezing emerging markets (EM) in classic late-cycle fashion. This shift could get ugly if it spreads to other markets, exposing more rocks as the liquidity tide recedes. In EVERY past cycle the locus of every crisis has been where debt has increased the most. This cycle it is in sovereign debt, which has enjoyed unprecedented demand from central banks and market flows. A term premium normalization would put monetary and fiscal policy in a bind, and we are closely observing global risk spreads to see if liquidity concerns are spreading. So far it has been minimal, but the liquidity drain will accelerate in 2019.
For now, liquidity concerns have been contained in EM stress, which has reinforced the dominance of U.S. momentum trends as capital has rushed to U.S. shores. However, the continuation of these trends will put pressure on U.S. profit margins as capital intensity, labor costs and interest costs rise. On the last metric, U.S. corporate net debt has never been higher outside of a recession, and rising rates are a key long-term vulnerability.
Pressure on profit margins is a key risk factor, as earnings growth from the tax cut and faster U.S. economic growth have been offsetting value multiple compression to drive U.S. returns. Earnings growth will naturally slow in 2019, but we would also expect material negative estimate revisions as margins come under greater than expected pressure. The combination of slowing earnings growth, negative estimate revisions and continued multiple compression could create an acute challenge for U.S. momentum. Given the crowding into U.S. momentum and the S&P 500, liquidity is a key risk if current extrapolation is challenged by the pain of missed expectations and any resulting price weakness.
…The clearest example of a current valuation opportunity that could benefit from changing dynamics is in financial stocks, and specifically insurance stocks that will benefit immensely from any normalization in the term premium and higher rates. We did not add any financials this quarter, but we have increasing confidence in supporting our fondness for financials with our holding in AIG. We think the new management team is turning around this global insurance franchise, and that the reduction in expenses and lower insurance losses will start to deliver earnings growth. The internal leverage from a successful turnaround could grow earnings even in a recession, which is a massive and favorable contrast with recession risk for S&P earnings. Despite the potential for scenario-agnostic earnings growth for AIG over the next several years, investors are reluctant to step up, and AIG stock continues to languish at distressed valuation multiples below book value.
Outside of these more traditional value areas, we remain positioned in large-cap drug and biotech stocks. The negative momentum and derating in this sector has been more painful than we expected, but these very high-quality stocks have fallen to prices that are discounting disruption of legacy cash flows and giving us pipeline optionality at an historic discount. Along these lines, we added a small position in Biogen during the quarter. Biogen is the market leader in the multiple sclerosis treatment market and the front runner in the race to conquer Alzheimer’s disease. The company’s current product portfolio has a value around $270 per share. This leaves its Alzheimer’s pipeline priced at about $75 per share, implying that the market only assigns a one-in-three chance that Biogen will succeed in Alzheimer’s. Favorably, Biogen has not one but two drug candidates that have both shown efficacy, albeit in early studies. We think there is a two-in-three chance that the drugs will work, and therefore we view the Alzheimer program as a very cheap option. If Biogen succeeds in Alzheimer’s, the stock could be worth around $550, a 60% upside. If it fails, the stock could fall 20% to the value of its existing business.
…Value has performed relatively poorly since the 2017 shift, but we believe challenges to the S&P 500’s dominance are mounting and resulting active opportunities away from the index are growing. At some point, this fault line will break, likely on the back of rising rates, and all investors will be reminded that the best time to diversify away from the winners is when it is most painful. The bargain of capturing long-term value may be short-term pain, but enough is eventually enough and it comes time to harvest the benefits.
Disclosure: None. This article was originally published on Insider Monkey.
