STRATEGIES

The time is now to move from value to growth stocks, writes Jon Markman of Strategic Advantage.

The Vanguard Group just published a report declaring that the most important factor for predicting future performance over the past 86 years has been valuation.

Seems like a no-brainer: if you pay little enough for a stock, it has the best chance of outperforming for you in the future. But actually, the question gets a little more interesting when you start to think about where valuation comes from.

As Steve Reynolds of Craig Drill Capital put it in a note to clients, as economic and corporate fundamentals weaken, investor sentiment worsens, leading to falling stock prices and thus lower valuations. Conversely, as conditions improve, spirits are buoyed and markets advance. So the most effective way to manage money is to master the timing of the swings of psychology.

Both bad and good news show up as P/E multiples. Bear-market P/Es tend to base around the seven to eight level for big stocks, while in bull cycles they tend to top out around 28. And as Reynolds points out, the range of underlying economic outcomes are significantly less volatile than the extremes of investor psychology—and therein lies the opportunity for traders and investors.

So if past personal experiences influence current sentiment, strategists should study investors' recent financial history in order to assess their future willingness to purchase equities. The more positive investors feel about their current financial conditions, the more likely they are to purchase equities. Conversely, negative experiences lead to equity liquidation.

Reynolds argues that the US stock market is now at this inflection point. Looking forward, additional market gains will increase confidence, and equity risk preferences will continue to rise. Then, the eventual self-reinforcing interplay between extreme euphoria and imprudent leverage will culminate in speculative excess.

The good news is that we appear to just be in the rehabilitation phase of the market psychology cycle, and are embarking on a period of wealth creation.

The best part of Reynolds' analysis is coming up. He notes that even though improved market psychology is on the cusp of enticing investors to take on greater risk, the economic outlook continues to be relatively uninspiring. For investors, this is troublesome, since the number of companies able to demonstrate strong, organic revenue and profit growth is rapidly declining.

Investors now have a rising propensity to increase equity exposure and a declining universe of attractive investment alternatives! He calls this the "Reynolds Paradox," and it is a very clever concept.

Portfolios invested in high-yielding, slow, and no-growth will find themselves caught in "value traps," which will necessitate methodically moving into a faster lane. As a result, Reynolds argues that the transition to growth stocks is just around the bend.

At the peak of this sentiment cycle, confidence will be so elevated by bulging wallets and inflated egos that investors—traveling at high speeds, trusting only their rear view mirrors—will recklessly ride off the road, he concludes. But don't worry too much about what will happen far down the road. The joyride has barely begun, and has many miles to go before it is done.

My recommendation: Be prepared to buy growth stocks now—techs, financials, industrials—and don't remain anchored in the value-oriented, consumer staples, dividend-focused world of the past few years. In short, it may not look like a time to bet on an improved economy, but really that is the best time to do so.

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