Value stocks may be positioned for another comeback based on these 3 factors.
by Denise Chisholm, Director, Quantitative Market Strategy, Fidelity Investments
Key takeaways
- Three drivers of value stocks are recent performance, capital expenditures, and interest rates. These factors may be lining up for a value stock recovery in coming months but only time will tell.
- On the performance front, value stocks dipped by more than 6% from June through August. Historically, a correction of that magnitude has been followed by outperformance over the next 6 months.
- For capital spending, inventories are very low now and historically when the ratio between inventories and shipments has been this low, new order growth, a measure of capital expenditures, has increased 8% year over year, on average.
- Rising interest rates are often a sign of a robust economy and have historically been a boon for value stocks. In the past, when yields have fallen as much as they have recently, interest rates rose over the next 6 months.
Historical patterns can help investors build conviction about future trends. Using history as a guide, here are 3 key value drivers that could signal a constructive outlook for the value trade: recent performance, capital spending, and interest rates.
1. Recent performance: Was value's summer correction a seasonal slump or potential opportunity?
Value stocks dipped by more than 6% from the beginning of June through August, a swift and sharp correction registering in the bottom 6% of 3-month returns since 1990 (see Sharp 3-month declines for value stocks are relatively rare). Historically, this trend has been somewhat seasonal—spring outperformance is typically followed by a giveback in the summer months, though not typically to this degree.
Although the historical seasonal return patterns have tended to be lackluster into the fall and winter, corrections like what we've seen have most often been buying opportunities. Importantly, the historical odds of outperformance have been as high as 80% with substantial alpha (especially on book yield) if the US avoided a recession over the next year (see Value stocks up in the 6 months after a sharp 3-month correction).
Alpha measures an investor's or portfolio manager's ability to outperform a market index. Alpha is a measure of the difference between a portfolio's actual returns and its expected performance, given its level of risk. Book yield is the ratio of a company's share price to reported accumulated profits and capital.
2. Capital spending: The makings of a durable recovery
What's more, capital expenditures (capex) surprised to the upside again in August, though the pace of year-over-year growth has begun to slow. Capex, a measure of business investment, tends to rise early in the business cycle when the economy is recovering following a contraction in growth. This phase of the cycle has historically favored risk-on positioning due to accelerating economic gains. Inexpensive stocks have tended to benefit during these periods, as beaten down valuations may provide greater upside potential if earnings improve amid a backdrop of strong growth.
This capex recovery stands in sharp contrast to prior cycles, given the steepness of the inventory decline. While a drawdown in inventories (relative to shipments) is typical as capex accelerates, this cycle has seen inventories decline at 4 times the average rate (see Recent drawdown in inventories much sharper than average for capex recoveries), due in part to bottlenecked supply and pent-up demand, but also a result of a pickup in wage growth and government stimulus payments. When the inventory-to-shipments ratio has been this low historically (in the bottom decile of its range since 1992), new order growth (a measure of capex) has increased 8% year over year on average.1
3. Interest rates matter for value
Yields on the 10-year Treasury note plunged more than 20% from May through August—a rare event that has occurred just 3% of the time historically.2 In the past, declines of this magnitude have resulted in higher yields over the next 6 months a majority of the time, but 96% of the time when the US economy avoided a recession over the next year (see Sharp declines in nominal rates have often resulted in higher rates over the next 6 months). Like strong capex growth, higher interest rates often signal a robust economy and thus provide a solid backdrop for value stocks. In fact, the correlation between growth in investment spending (a key component of GDP) and 10-year Treasury yields has been 0.74 over the past 10 years.3
Given that value's recent sharp correction may present an opportunity, I'm keeping my eye on capex and Treasury yields to reinforce what appears to be a constructive outlook for cheap stocks into next year.
About the expert
Denise Chisholm is the director of quantitative market strategy at Fidelity. She evaluates historical market patterns to help investors build conviction about future trends.
