by Abhishek Ashok, M.A., MFE, CFA® & Stephen Duench, CFA®, AGF Management Ltd.
Growing concerns about central bank tightening caused an extreme rotation in equity markets over the first few weeks of the new year. Namely, value stocks were bid up and outperformed relative to other factors such as momentum and growth, which have been two of the dominant trades for much of the past two years.
The reason? Not surprisingly, investors seem worried that potential rate hikes and a possible reduction in the U.S. Federal Reserve’s balance sheet will have a greater negative impact on earnings of long-duration growth stocks and have been selling them in favour of more value-oriented cyclical stocks with nearer-term cash flows that won’t be so impacted.
Yet, what is perhaps more critical about the recent rotation is the magnitude of it. According to our research, value’s relative performance to the rest of the U.S. market has rarely been more impressive when comparing weekly returns over the past 20 years. Moreover, this extreme is echoed to varying degrees in other large developed markets including Japan and Europe.
Two-Week Performance Spread of Cheapest Versus Expensive U.S. Stocks
Source: AGFiQ with data from FactSet as of January 14, 2021. Chart measures the rolling 2 week performance spread between the cheapest and most expensive (based on price-to-book ratio) quintiles of stocks within the largest 550 securities in the U.S. by market capitalization.
To be more exact, “cheap” stocks have rarely, if at all, performed this well versus expensive stocks as measured by value metrics such as price-to-book, free cash flow yield and forward price-to earnings. The only other times that even compare are the period near the very end of the Global Financial Crisis in 2009 and two other, more recent occasions, including March of 2020 following the initial COVID-19 pandemic selloff and when the first vaccine against the virus was approved for use by U.S. regulators later that same year.
Of course, whether this dynamic continues from here may largely depend on what happens to monetary policy and its impact on the economy going forward. After all, value tends to perform better in rising yield environments and during expansionary economic phases characterized by sustained Purchasing Manager Indexes.
At the same time, it’s interesting to note that value has become far less correlated to market moves than it was in the past and may now be considered by some investors as a way to hedge risk during the next downturn in markets.
Still, investors need to be careful either way. The entry point into value stocks broadly speaking is not nearly as attractive as it was just a short time ago and factor trades this extreme rarely persist and could be a signal of a near-term reversal.
In fact, one indication that value’s outperformance may fade going forward is the narrowing valuation spread between cheap and expensive stocks as the result of recent returns. Again, based on our research, value is more neutrally priced today than it was a few weeks ago, while growth stocks are not nearly as expensive – at least on a relative basis – as they once were.
Valuation Spread of Cheapest Versus Expensive Stocks
Source: AGFiQ with data from FactSet as of January 14, 2021. Chart measures valuation spread (Z-score) between the cheapest and most expensive (based on price-to-book ratio) quintiles of stocks within the largest 550 securities in the U.S. by market capitalization.
Ultimately, the best option for investors now may be a blend of both value and growth stocks that have attractive valuations and exhibit high quality characteristics. This combination might help bolster returns over the next few months, but also mitigate some of the heightened market volatility that is widely expected at this juncture in the cycle.
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The views expressed in this blog are those of the authors and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds, or investment strategies.
The commentaries contained herein are provided as a general source of information based on information available as of January 17, 2022 and are not intended to be comprehensive investment advice applicable to the circumstances of the individual. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Market conditions may change and AGF Investments accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained here.
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This post was first published at the AGF Perspectives Blog.
