The Q3 season tells us that any additional growth from the tax reform is now behind us and that corporate America is back at cruise level. The share of earnings beats, the size of surprises, guidance and next year’s expectations have all reverted to their long-term average.
After a rough start to the season, when any earnings disappointments were severely sanctioned, prices then became increasingly consistent with the stock’s fundamentals, i.e. a key pattern for managers who need prices to reflect the fundamentals they pick stocks for.
Meanwhile, increased dispersion at stock and sector levels, and moderate correlations would also provide a variety of arbitrage opportunities. These should emerge after the dust settles, when stock trends reshape again. More reasonable earnings expectations would also lower the hurdle. U.S. equities also showed a wider sector leadership, with cyclicals matching tech stock contributions.
These improvements are not a coincidence in our view. They come at a time when the U.S. economy is probably peaking, thus curtailing market directionality. The effects of the Fed’s hiking cycle are starting to be felt, with increased discounted cash flows and leverage differentiation. The fading impact of the tax policies should also allow, to some extent, sector and factor rotation to respond to traditional drivers (growth, rates, risk on/off etc.) rather than to transversal movers.
More arbitrage opportunities from low correlation, more fundamental stock differentiation, and greater price rationality, a reset for most equity trends, are all key ingredients for stock-pickers.
This is not to say the alpha environment is ideal yet. For now, a majority of L/S Equity managers have shrunk their cyclical exposure overall, and would only partially benefit from a rally, if any. Moreover, further political uncertainty is still a major alpha issue, in particular trade tensions, which are likely to unsettle stock-picking opportunities for a while. With these nuances in mind, we are considering reweighting U.S. stock-pickers.
