A year of rising markets has seen investors switching into growth stocks to try to ride the wave, with the defensive names favoured during the years of crisis underperforming in relative terms. Gregory says this trend has now run its course and that sideways-moving markets are much more likely. Investors need to concentrate on finding managers who can pick the right stocks rather than judge the macro correctly, he adds.
"I dare not say that we are now in a stockpicker's market, because for so long we have been in a risk-on/risk-off political brinkmanship mode, but in my view stocks no longer have the 'rising tide floats all boats' support they previously enjoyed and they will need to raise the bar and show their investment worth on an individual basis," he said.
Data from FE Analytics shows that over the past year, growth stocks in the UK market – using the FTSE 350 lower yield index as a proxy – have outperformed high yielding stocks, in stark contrast to the results over three years.
Performance of indices over 1yr
Source: FE Analytics
There appears to have been a shift in investor sentiment to the two areas of the market, but Gregory says it is now entering a new phase.
"It strikes me that we have moved through two phases of this equity bull market and we may now be entering the third and final phase," he said.
"Defensive bond proxies rallied as investors latched on to the idea that interest rates were going to be low forever."
"Therefore, the best investments were high-quality sustainable franchises of global companies that could pay dividends, which in many cases were in excess of the corporate bond equivalent coupon rate and also were growing those dividends."
"These trades played out very well until the stock prices rose to levels where there was no further room for multiple expansion and in addition bond yields finally rose, reducing their attraction."
"There was a big catch-up trade in the more cyclical parts of the market, which had been left behind by the rally in 'expensive defensives'."
"In the second phase, recovery sectors such as banks led the markets higher, performing very strongly and narrowing the valuation gap to the defensive sectors of the market."
"It seems to us that although there are still a number of cyclical recovery plays that are attractive, the structural revaluation of this part of the market has also run its course."
"This third and final stage may just be commencing. This is the stage of the market where the global economy continues to tick along in its sub-optimal way, hindered by politics but helped by a pickup in Europe and Japan."
"With valuations now fairly full, we need to focus on those companies who are demonstrating good top-line growth, which through operating leverage pushes earnings higher, justifying the multiples we are now being asked to pay for stocks."
Gregory says that after a period in which macro concerns returned as the main drivers of markets in the US – with negotiations over the debt ceiling particularly important – investors are now concentrating more on earnings growth.
The result will be to see a much more differentiated market in which picking companies that are producing solid results will drive returns.
"It’s the third week of the earnings season and result after result is going through the tape in what seems like an endless blur of numbers, reiterations of guidance and understandably cautious commentaries."
"In the US, 140 companies from within the S&P 500 have already reported and at the headline level, 74 per cent of companies beat earnings and over 50 per cent have beaten revenues."
"In the lead-up to the results season, a record number of companies reduced guidance, so the bar had been set quite low and in fact no growth was expected in earnings for the US market as a whole this season."
"Such was the noise from debt-ceiling extension negotiations that the disgraceful antics of Washington politicians overshadowed the approach to this results season."
"Whilst it is impossible to suggest that our attention will not be re-focused towards tapering and debt ceilings in early 2014, if not before, we believe earnings and revenue growth will most likely play an increasingly important role in market returns from here on in."
The result of this shift in emphasis will be to highlight how expensive some stocks have become, Gregory says. This means companies will be more exposed if they cannot demonstrate growth.
"Stocks have rallied very strongly this year, such that many markets are now sitting at or near all-time highs," he said.
"Valuations have moved up significantly and as 'quality' sovereign bond yields have also risen from the very low levels of earlier this year, equities no longer look optically 'stand-out value'."
"In fact, it is quite easy to look at the valuations of many assets and struggle to find any great anomalies."
"I wish the very best of luck to the asset allocators putting together their strategies for 2014 and beyond."