This second blog post of a three-part series looks at where we see vulnerabilities in the marketplace. Part 1 discussed indicators that we’re in the later stages of this profit cycle, and Part 3 will explore support factors for the market over the next several years.
While investors may be riveted by Hollywood’s surprise endings and cliffhangers, they generally aren’t fond of unexpected plot twists in the market. So here’s a spoiler alert. The operating results of companies in the current cycle have been quite strong, and many investors expect this to continue. But we’ve seen enough plot twists over time to know this can be a risky assumption.
Visible vulnerabilities
We see vulnerability in these areas:
- Expectations for profit growth are overly optimistic, in our view, given the degree of operating leverage remaining for companies at this later point in the cycle.
- The current near-zero, risk-free rate of return is distorting the implied cost of capital. While the degree of distortion remains unclear, investors typically make more volatile assumptions about a firm’s long-term cost of capital during inflection points.
- There is potential for a disorderly unwind of monetary policy, given that potential tightening by the Federal Reserve is starting so late in the profit cycle versus other central banks. In addition, divergent directions among central banks regarding monetary policy could create crosscurrents that may have a very large distortion on money flow, which has historically led to dislocation.
- A slowdown in Asia could negatively impact European sales, which are heavily dependent on exports to Asia. The slowing European economies could then domino to slow US exports to Europe.
- Overreliance on past correlations to estimate how the market will act under any given macro forecast is a consistent problem over time. In our view, the most prevalent example of flawed overreliance on past correlations is forecasts of how various assets will behave during periods of rising interest rates. Much of the available data is based on the past 30 years, a period that saw a secular decline in rates with only intermittent periods of rising rates. Today’s starting point for interest rates is both dramatically different from other historical periods and highly distorted by unconventional central bank actions across the world.
As value investors, we are constantly on guard against complacency. The key is balancing these concerns with supporting market factors, which I discuss in the third part of this series.
For a more comprehensive analysis, please see the Insights titled Dividend Value Investing: No Time for Suspension of Disbelief. You may also be interested in information about Invesco Diversified Dividend Fund and Invesco Dividend Income Fund.
Important Information
The cost of capital is the opportunity cost of an investment; that is the rate of return that a company would otherwise be able to earn at the same risk level as the investment that has been selected.
Correlation is the degree to which to investments move in relation to each other.
A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.
Common stocks do not assure dividend payments. Dividends are paid only when declared by an issuer’s board of directors, and the amount of any dividend may vary over time.
