Boxes containing the Pfizer-BioNTech Covid-19.
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Value stocks’ recent outperformance has occurred as the economy has come out of recession. The question now is whether that performance has legs—or is set to be short-lived.
Value stocks—the name given to the market’s cheapest and most economically sensitive stocks—have been outperforming in the fourth quarter. Since Sept. 2, the Vanguard S&P 500 Value exchange-traded fund (ticker: VOOV) is up 6.8%. The S&P 500 is up 3.6% over that time, and the Vanguard S&P 500 Growth ETF (VOOG) has climbed about 0.9%. (The Vanguard Growth ETF invests in companies that are expected to see sales growth no matter the economic environment, but aren’t always profitable today.)
That marks a sharp shift from earlier in the year, when value stocks were drastically underperforming growth stocks. Yet value’s outperformance isn’t because of a fundamental change in the way the market is working, at least not yet. Rather, it’s because investors expect economic growth to rebound.
That makes sense given that millions of Covid-19 doses are on track for distribution within the next year and a new fiscal stimulus package is nearly finished. Many corners of the economy have exhibited near V-shaped recoveries, and expectations are for continued strength.
Not only would such an upturn benefit cyclical stocks in the oil, financial, manufacturing and consumer-discretionary sectors, but inflation may be reflected in the pricing of their goods as well.
What’s more, Treasury yields and other benchmark interest rates tend to rise during an economic expansion to reflect higher inflation. Those higher rates lower the value of future corporate profits. That’s because analysts use a “discounted cash flow analysis” to assess the intrinsic value of a company by forecasting their cash flow then “discounting” it back to the present day against a risk free rate. When rates rise, those cash flows are worth less, and since growth stocks are reliant more on future cash flows—they may even be money losers—making growth companies more sensitive to rate changes. If a long-term increase in rates is in the offing, value could outperform growth for years.
Unfortunately, the recent rotation into value stocks may merely be a function of an expectation that economic activity will rise with the end of the recession and then stabilize, causing value’s outperformance to dissipate. Some Wall Street strategists expect growth stocks’ earnings momentum to carry them to strong gains, and argue that valuations have become more reasonable in the past several months. That doesn’t mean value can’t run hot alongside growth, but longer-term outperformance may be unlikely.
That’s the view of Barry Bannister, Stifel Nicolaus’s head of institutional equity strategy, who expects the current trend to last—at most—a few years. He thinks the trend is the result of a short-term bounce out of a recession, not a secular, or long-term, shift into value. Bannister references history in his note: Value-stock leadership becomes secular almost 10 years after commodity prices trough, he found. For example, value stocks led the market for roughly a decade starting in 2000—after a 1990 bottom in commodity price growth. A similar dynamic occurred in two other periods dating back to the 1930s. But commodity prices are still on the decline now, and have been since the financial crisis. If that’s the case, values leadership may not even last as a shorter-term event, Bannister writes.
In fact, there have been two other brief periods since 2016 in which value stocks fared better than their peers, but those were mere “head fakes,” Bannister writes.
Value stocks can continue to outperform for a while, but don’t be shocked if they fade just as quickly.
Write to Jacob Sonenshine at [email protected]
