Rational Concerns and Irrational Excesses

 “Excesses are never permanent.”
—Bob Farrell
Wall Street Veteran and Legendary Investor
 
 
The economy continued to surge during the third quarter. Employment was strong, manufacturers continued to chug forward and consumers remained bullish. The upbeat data reignited a fear of missing out on the part of investors. As a result, money poured into the market and the major equity indices notched new highs during the period. 
 
Asset flows underscored the renewed appetite for risk. By some industry estimates, the amount of cash invested in exchange traded funds (ETFs) that are focused on momentum has jumped 50% since the beginning of the year. One $70 billion ETF that tracks the 100 largest holdings in the growth-oriented NASDAQ ballooned by 8% alone.
 

Overstretched?

The rush into growth and momentum continued a familiar trend and further stretched already elevated valuations. Meanwhile, some attractively priced areas where fundamentals appear to be improving failed to keep pace. 
 
While equity investors focused on participating in near-term upside, economic prospects over the long haul remain unclear. The impact of recently enacted trade tariffs and higher interest rates have yet to be fully felt. On the other hand, tax cuts are expected to provide an additional lift for consumers and could have a spillover effect for the economy. 
 
As the chart below highlights, fixed income markets appear to be flashing caution. As shown, the yield curve is flattening—which often points to lackluster economic prospects. Equity investors, however, have been avoiding defensive areas of the market. This divergence of views, we believe, highlights the value of a bottom-up investment approach that focuses on the strengths and weaknesses of a company regardless of the economic backdrop.
 
A Surge in SmallHeartland Advisors Value Investing Treasury Yield minus T-Bill Chart


Source: © Copyright 2018 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.
Bond Equivalent Yield (BEY): allows fixed-income securities whose payments are not annual to be compared with securities with annual yields. The BEY is a calculation for restating semi-annual, quarterly or monthly discount bond or note yields into an annual yield, and is the yield quoted in newspapers. Alternatively, if the semi-annual or quarterly yield to maturity of a bond is known, the annual percentage rate (APR) calculation may be used.
Past performance does not guarantee future results.

The Problem with Good Intentions
The current excess in valuations for growth and momentum is in our view a misguided response to a rational concern. Investors are understandably cautious about the ability of companies to grow in the face of rising rates and political uncertainty. By chasing yesterday’s winners, however, investors have created excesses in valuations, and as Mr. Farrell rightly noted, excesses are never permanent. 
 
While we are monitoring these developments, the results will not change our philosophy or process. We continue to seek attractively valued companies across all sectors. We remain focused on balance sheet strength and on identifying catalysts that can result in a change in perception by investors. We believe this disciplined application of our process will be key to navigating the quarters ahead.
 
We thank you for your continued trust and confidence.
 
Sincerely,
Your Heartland Team

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Past performance does not guarantee future results.

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