by Jim Jomlin, Russell Investments
It’s coming. Is it here? Perhaps. Or maybe not. But sooner or later, it is coming. Preparing now for the eventuality seems the most prudent course.
Investment markets share certain characteristics with earthquakes. Pressures mount as forces shift out of balance. Hopefully gradually, and sometimes most suddenly, these forces revert to a more balanced state and the process begins again.
Seismology and investing share similar objectives of trying to predict largely unpredictable breaking points, leading to the release of built-up imbalances. For earthquakes and investing, long periods of mounting pressure create the potential for catastrophic outcomes, as the sudden rebalancing of underlying forces mark the end of one cycle and the start of a new one. The pressures, or imbalances, seem obvious, but trends persist nonetheless. Until they don’t. Investors, like homeowners considering earthquake insurance, are best served by preparing for these inevitabilities, even while recognizing the limited predictability.
Increasing pressure on a value recovery
For the last few years, value-oriented investors have been waiting (and waiting) for the inevitable big one to arrive and finally compensate them for an agonizing wait. They’ve been watching their growth counterparts, the metaphorical builders of mansions on coastal fault lines, enjoy a surprising windfall. While a value recovery seems likely by its repeated occurrence throughout market history, it feels to many like we are waiting for something that might never come. The recent performance of growth stocks, on the other hand, might be described as its own tsunami, a relentless, seemingly unstoppable force arising from its own set of circumstances leading to its own big one.
At the time of this writing, growth stocks—as measured by the S&P 500® Growth Index—have gained nearly 35% over the past year on a total return basis. Value stocks, in contrast, have pretty much gone nowhere, with a meager gain of 3.3%.
Investing like it’s 1999
These are almost definitely unsustainable trends. The imbalances are approaching unprecedented levels by the lengthiest of historical periods for the stock market. Much like earthquakes, the time between such disruptive changes in the stock market can be quite long. Many in the investment business in 1999 see similarities in the tone and tenor of that period in stock market history with what we see today. Revolutionary new technologies come alongside the seeming decline of many old-line businesses. Enthusiasm for these technological marvels results in speculative and seemingly irrational pricing of expectations for things that usually never met the expectations reflected in their share prices.
Let’s look at one example: Tesla, one of the poster children of growth’s phenomenal run, has seen its stock rise an incredible 960% over the same period. Tesla, inarguably an exciting company, led by a charismatic and perhaps brilliant visionary in Elon Musk, has fascinated the public, leading the brand to become one of the world’s largest companies by stock market value. While Tesla’s electrical vehicles have been considered somewhat revolutionary, its rivals have begun to introduce their own impressive alternatives. A new competitive reality awaits. Plus, the fact remains that Tesla is a profitable company not by the sales of its vehicles, but mainly by the benefit of its emission credits, which it sells to old-line automotive companies, in effect, for the right to pollute.
Truth demands a closer look
Yes, many stocks in the value category seem like dinosaurs in a world of rapid technological change. Particularly, when these technological changes have been accelerated in adoption and need by the lockdowns associated with the COVID-19 pandemic. Financial services and energy companies—the two most dominant sectors in the value indices—have seemed a fool’s peril. Few speculate for the complete demise of financial companies, though many believe the earnings power of many may be permanently impaired by chronically low interest rates, and pent-up anger for misdeeds of the past, such as the financial crisis of 2007-2009. Others see a promising future for well-managed banks, insurance companies and other financial services providers. This future promise is tied to growing demand, their own form of technological advances—such as Venmo—and a steadier economic climate, post-COVID.
In contrast, many believe a world free of fossil fuels is within reach. They see fossil fuel extractors and distributors as in a state of steady decline. The truth is less clear. While Russell Investments has a strong focus on ESG investing, we also recognize that some experts see a harsher environmental and social impact from electric vehicles (EVs) than modern internal combustion vehicles. When the huge environmental and social toll of lithium mining and disposal is considered, the clean energy story for EVs becomes a bit muddied. In addition, some of the largest producers of green energy are the very companies known as fossil fuel brands. These companies still remain a critical part of a functioning world and the economics of energy production seem far more certain than what is reflected in the current stock prices of energy companies.
Many stock market investors, professional and amateur alike, have lost patience with value stocks. Narratives have emerged to support that impatience. This loss of faith is not new to participants in investment markets. We have witnessed similar periods of enamorment and loss of faith many times in the past. The aforementioned dotcom market of 1998-2000 is the most recent precedent for most, but Japanese stocks in the late ‘80s (Who of the time did not take Japanese lessons, or at least consider it?) is a slightly more distant memory. Some industry veterans still remember the Nifty Fifty of the late 1960s and early ‘70s and some disastrous consequences for investment managers and their clients. History may not exactly repeat, but the rhyme can be heard.
Always never different this time. And this one too shall pass.
We financial professionals are not allowed by regulatory law or by professional ethics to guarantee investment outcomes, but it is very, very likely better trends are ahead for value. Once again, the earthquake analogy seems appropriate: We know it is coming. We had better be prepared. It may not happen tomorrow. But it could be.
The stock market is a dynamically changing reflection of cyclical conditions, individuals’ assessments of value and people’s attitudes. Recent trends have been very good. After a rather scary decline in share prices early in the year, stocks have surged on hopeful signs that the worst may be behind us. Say what you will about 2020, but stock market investors have done okay. U.S. stocks are up nearly 15%.1 Non-U.S. stocks have lagged, but even they are up almost 6%, despite it all.2 And while value shares have lagged by quite a bit year-to-date, there are hopeful signs for value investors, as value stocks have led the way in the final quarter of the year. It may not take a painful market correction and its tsunami of knock-on effects to reward patient discriminators of stock values.
1 Source: SP&P 500® Index, as of Dec. 10, 2020
2 Source: MSCI ACWI ex-U.S. Index, as of Dec. 10, 2020.
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