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Peaking economic activity and slowing growth are characteristics of a late-cycle economy.
Quality stocks — shares of companies with strong balance sheets — tend to perform best during these periods, according to the firm. According to Bank of America’s analysis, high-quality stocks have outperformed the equal-weighted Russell 2000 in every late-cycle period since 1990.
“Our work supports owning Quality – which has historically been rewarded most during that phase,” said Jill Carey Hall and Savita Subramanian of Bank of America in a note.
Following the breakout of Covid-19 in April of 2020, the recession officially ended in April of 2020, and now, after only 16 months, the expansion may be slowing. According to economists polled by FactSet, the economy will continue to grow at a 6 percent annual rate for the rest of the year before slowing to 4 percent in 2022.
Bank of America identified stocks in the Russell 2000’s top quintile that had either a high free cash flow return on assets or a high return on capital — two top-performing factors in a late-cycle economy.
The firm narrowed its list to stocks with a buy rating from Bank of America analysts.
Bank of America’s list is dominated by consumer discretionary stocks.
Bed Bath & Beyond made headlines earlier this year when it became entangled in a speculative trading frenzy among retail investors. However, a number of Wall Street analysts believe the company has a chance to turn things around. In terms of free cash flow return on assets, Bed Bath & Beyond ranks in the top quintile of the Russell 2000.
Stock photography company Shutterstock, upscale home furnisher RH, and wholesale retailer BJ’s are among the other consumer discretionary names on Bank of America’s list.
Quality small-cap stock picks from Bank of America also include health care, energy, industrials, information technology, materials, and real estate.
Among the other companies on Bank of America’s list are Vanda Pharmaceuticals, Allegiant Travel, and Northern Oil and Gas.
Goldman’s favorite energy stocks
The group’s decline has lagged that of oil, which has risen from a two-year average of $52 per barrel to $70 per barrel since September 2016.
Changes in strategy, leadership developments, and macro improvements, all of which can drive mean reversion, are catalysts for companies on the firm’s turnaround list. Each name has a buy rating from Goldman.
Exxon Mobil is one of the companies on Goldman’s list. The company’s stock has risen nearly 40% this year, but it is still down 32% over the last five years. According to Goldman, the stock has dropped 14 percent in total return, or when the company’s dividend is factored in. According to the firm’s analysis, Exxon is the worst performer among the oil majors.
Several factors have weighed on the stock, including negative earnings revisions, weakness in downstream operations, and a lack of clarity regarding long-term emissions reduction plans. Nonetheless, Goldman stated that a “significant turnaround is underway.”
In a note to clients, analysts led by Neil Mehta wrote, “The company has reduced costs, surprised to the downside on capital spending, outperformed our expectations in Downstream/Chemicals, and developed an outstanding resource in Guyana.” Mehta also mentioned improved earnings transparency in recent quarters, after Exxon had one of the highest miss rates in the S&P500.
Occidental Petroleum, an exploration and production company, is also on the list, with total return down 54% over the last five years, according to Goldman. Mehta attributes the poor performance in part to the company’s acquisition of Anadarko Petroleum just before the pandemic, which reduced demand for petroleum products.
“At current favorable commodity prices… we see potential for shares to improve through balance sheet improvement, and over time with success in OXY’s Low Carbon Ventures business,” the company said. “There has been no change in leadership, but we believe the business’s strategy has fundamentally shifted from one of growth to one of deleveraging.”
Baker Hughes has the clearest turnaround story going forward among energy services companies, according to Goldman. Over the last five years, the company’s total return has been a loss of 23%.
According to the firm, the stock has fallen due to the company’s underperforming legacy businesses. Baker Hughes, on the other hand, has recently shifted to higher margin and higher growth activities, such as carbon and hydrogen end markets.
“BKR intends to operate its industrial and traditional Energy businesses separately, indicating that management is considering all options for unlocking value,” Goldman said of Baker Hughes, which is on the firm’s conviction list.
Disney (DIS)
“Disney cruises are doing extremely well. Cramer said on “Squawk on the Street” that “Disney is back.” “I’m back with $171. It was less expensive than where I sold it.”
Disney shares fell 4% to $171.17 per share on Tuesday after CEO Bob Chapek spoke at the Goldman Sachs Communacopia Conference. He forecasted headwinds for subscription video streaming growth in the fourth quarter and stated that the company will not reinstate its dividend anytime soon.
“That shattered the stock. But it provided us with the opportunity to buy,” Cramer explained. Late Tuesday, the charitable trust purchased the stock.
When the “Mad Money” host announced in June that the trust was selling Disney, the stock was trading just above $173 per share.
Cramer stated on Friday that Chapek’s leadership, who will take over as CEO from Bob Iger in late February 2020, is a key reason for his renewed confidence in Disney.
“People who just play him as ‘Disney+ versus people going to the movies’ are completely missing the point,” Cramer said. Disney+, the company’s streaming service, has been a major growth driver, particularly during the Covid pandemic, when millions of people spent more time at home and craved on-demand video content.
“He takes a very holistic approach. That is not an exaggeration. He’s looking at the entire Disney universe, and I think he’s making a lot of sense,” Cramer added. Before taking the helm, Chapek was chairman of Disney parks, experiences, and products.
Despite the praise, Cramer believes Chapek made a mistake when he said the dividend and share repurchase program would resume in the “distant future.”
“That was incorrect. Cramer believes he should have said, “It’s up to the board.”
Disney shares were down about 3% year to date, compared to a gain of more than 18% for the S&P 500.
Guggenheim upgrades Roku
“We expect the connected television (CTV) ad marketplace to continue to grow at a rapid pace, with Roku being a primary beneficiary—our outlook remains unchanged. However, we believe that the company’s incremental international expansion, potential for additional targeted marketing partnerships, and expanded advertising tools are underappreciated,” the note stated.
According to Guggenheim, this could be one of the first steps toward a significant international expansion.
“We believe the company is well-positioned to accelerate the pace of international growth, thereby expanding the long-term addressable market.” We estimate that the company had 5.6 million active accounts outside the U.S.A.
Year to date, the stock is down 2.2 percent.
Guggenheim set a $395 per share price target for Roku, which is 21.6 percent higher than the stock’s closing price on Wednesday.
Well Fargo’s Steven Cahall downgraded Roku’s rating to equal weight from overweight on Friday, citing consensus expectations for a 50% and 47% increase in average revenue per user over the next two years. Cahall’s bull case is that the high expectations leave little room for error, according to the analyst.
“The primary reason we move from Overweight to Equal Weight is that, while there may still be a long ARPU runway, it is far better understood,” according to the note.
The analyst also mentioned new competition from companies such as Amazon, which recently launched its own branded smart TVs.
Cahall wrote, “The crowded marketplace leads us to a lower valuation multiple.”
Roku shares have calmed down this year after a surge during the pandemic as streaming boomed, and are roughly unchanged for 2021. Roku shares fell near the end of the summer after the company reported a slowdown in streaming viewing.
Following the Wells Fargo call, the stock was down more than 2% in premarket trading.
Are we approaching a slow economy?
One example is the 10-year Treasury yield, which rose to 1.43 percent on Thursday afternoon from 1.31 percent immediately following the Federal Reserve meeting on Wednesday.
Thursday’s stock rally was fueled by expectations that property giant China Evergrande would pay its debts and that China would not allow the firm’s failure to spread contagion throughout the financial sector. On Thursday morning, there was also news from Washington that Democrats had agreed to a framework to pay for their proposed $3.5 trillion reconciliation package, which helped boost bond yields and stocks.
“It appears that we have some good news about China. “The Democrats are attempting to demonstrate that they are making progress,” said Mark Cabana, Bank of America’s head of short-term interest rate strategy. “Those are two significant risk factors. Rates are reacting to this in some ways, but it also comes in the context of more hawkish central banks around the world. It comes in the context of a market that may have been looking for a clear break in one direction or another, and we may be seeing some of that break today.”
Cabana does not expect the 10-year to move much further, but he does believe the trend is upward for the time being. His end-of-year target is 1.55 percent. “The tens have been extremely restricted in their range. This is the highest reading since mid-July. Is it long-lasting? “I’m not sure, but it’s a bit of a break,” he explained.
In terms of the stock market, Leuthold’s James Paulsen observed a return of the economic reopening trade on Thursday, with the 10-year yield rising and small cap and cyclical stocks leading the market higher. The small-cap Russell 2000 outperformed other indexes, closing 1.8 percent higher, compared to the S&P500’s 1.2 percent gain. The energy sector outperformed all others, gaining 3.4 percent.
“I think underneath all of this is that Covid is peaking, and cases are starting to fall, and that will be another reopening cycle replay,” Paulsen, Leuthold’s chief investment strategist, said. “Every time there is a shift in leadership away from technology and defensives and back to cyclicals and small caps, yields rise, commodity prices rise, and confidence rises.”
September is typically a bearish month for stocks, and this past week put that theory to the test.
The week began with a steep sell-off due to fears of contagion from Evergrande’s potential messy default. The market then stabilized on Tuesday before whipping around on Wednesday as the Fed met. By Thursday, the stock market had erupted into a full-fledged rally.
According to State Street’s Michael Arone, risks remain, but the market has moved past three concerns that worried investors earlier this week. The first was Evergrande, and the second was that the Fed would reverse policy too quickly.
The Fed signaled on Wednesday that it would announce tapering this year, as many expected, and Fed watchers now believe it will be in November. Nonetheless, Arone said it was a relief that the announcement about slowing bond purchases did not come on Wednesday.
“Based on the challenges the economy was facing, the Fed decided to postpone the tapering announcement for the time being,”
Nonetheless, the Fed sent a hawkish message, saying it will be ready to reduce its $120 billion monthly bond purchases soon, and Fed Chairman Jerome Powell said he hoped to finish the process by mid-2022. This opens the door to interest rate increases, with half of the Fed’s 18 officials predicting one or two for next year.
“I believe investors interpret this as a sign that the Fed is confident that, despite a temporary setback, the recovery has a solid foundation.” They interpret this to mean that if we can get past the delta variant and some of the dysfunction in D.C., this recovery will regain serious traction,” Arone said.
Investors, according to Paulsen, have been bracing for the worst. “The issue I had with the emerging fear trade was that it was all too predictable for me. “You start September, the worst seasonal month, with everyone knowing the stock market is due for a correction,” he explained. The S&P500 is down 1.6 percent year to date.
“You enter September. You still have Covid on the rise. You’re aware that the Fed meeting is approaching. I’m just wondering if it was all overdone, not just this week, but since September 1st. “How many Wall Street firms issued warnings about impending volatility?” he asked. “That was done by everyone.”
Since the start of the pandemic, the 10-year has been the best leading indicator for stocks, according to Paulsen. The yield would fall ahead of the stock market and begin to reverse as the market recovered.
He also anticipates that some of the market’s concerns will dissipate. Congress, for example, will raise the debt ceiling and avoid a crisis, he said, implying that more Treasurys will be available on the market to fund federal spending.
“You intend to fund the government. “My prediction is that we will return to the 1.80 percent [yield] level that we had in March,” he said. “It’s because inflation will remain sticky. It is not going to fall as much, and the Fed is beginning to consider tapering. That is yet another bearish factor.”
The Fed’s new interest rate forecast, released on Wednesday, called for a rate of 1.75 percent in 2024.
At that point, inflation, according to Caron, will be running ahead of the Fed’s rate forecast. “If we consider inflation hovering around 2% to 2.5% and the Fed raises rates… to 1.75 percent, you’ll still have a negative policy rate, which is expansionary, not tightening,” he said.
