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After many years of underperformance, is now the time for the value style and factor to stage their come-back?
Factors positioning and valuation analysis show that investors are just “buying what’s working” more aggressively than usual. Momentum and growth factors have rarely been more expensive. The same can be said for the low volatility factor, as investors flocked into defensive market segments and strategies amid the rising uncertainty and risk aversion caused by the great financial crisis of 2008. Investors crowded into quality growth stocks — think FANG – in a bid to be well-positioned for a decelerating economy. So, can we say that valuation does not matter anymore? What can we expect for value stocks going forward?
While the value factor and style have rarely been so cheap, they do need fundamental support from the economy, lower policy uncertainty and rising bond yields to gain sustainable momentum.
Over the last 10 years, value, cyclical, and lower quality factors (i.e. lower profitability or Return on Equity) have been highly correlated with falling bond yields, flattening yield curves, and rising uncertainty. Today, yield curves are flat or even sometimes inverted in many countries across the world, while central banks look ready to loosen monetary conditions even further and embark upon a new globally synchronized rate cut cycle.
Undoubtedly, short-term rates will fall further, but a scenario of steepening curves could also materialize if markets finally believe that monetary stimulus (maybe followed later by additional fiscal stimulus) will succeed in reigniting the growth engine. Yes, some macro-economic numbers such as manufacturing Purchasing Managers’ indices are falling quickly, but consensus is so massively bearish that future surprises will probably print more on the upside. Drawdowns don’t occur when everyone expects them!
Further progress on the trade war could also be expected, while we are getting closer to the US presidential election and the new European Commission could launch ambitious reforms and stimulus plans across Europe. In a nutshell, policies and political uncertainty could ease, while macro-economic numbers could surprise positively and yield curves steepen (even just marginally) from here.
The valuation of the value style has been reaching levels rarely seen over the last 10 years. This high dispersion of valuations between the cheapest stocks and the most expensive ones offers a good cushion for the months ahead and creates opportunities for value and higher volatility stocks.
In contrast, momentum, quality and growth factors and styles, which have benefited from rising uncertainty and risk aversion, now look very expensive.
Source: Factset, Goldman Sachs Global Investment Research
As shown in the graph below, the valuation gap between low volatility stocks and value stocks has never been this wide in modern history. If macro-economic data disappoint further and the worst comes to pass, these past winners could bear the brunt of the correction, as investors will be quick to take their profits. However, they would underperform as well if macro-economic conditions improve much quicker than currently anticipated.
Relative forward price earnings ratio (US) of value stocks vs. the market and vs. low volatility stock
Source: JP Morgan QDS
Put differently, the value style needs either a sustained re-acceleration of global growth or at the other extreme, a full-blown recession forcing a premia re-pricing and quality momentum style underperformance.
We do not pretend that the secular uptrend of low volatility and quality stocks, which are becoming more expensive due to the secular decline in yields, will end soon. But there are potential catalysts that could warrant a rotation in favor of the value style some time towards the end of the year. They include the extreme divergence in valuations, extreme positioning in favor of the defensive sectors and the quality styles and factors, the underestimated potential for positive surprises on the macro-economic, geopolitical and policy fronts as well as a tactical correction and steepening of the yield curves.
As recently reiterated by Exane (see “the Nifty Fifty vs. the Shifty Fifty”), let us remember what happened in the 70s with the so-called “Nifty 50” stocks, the darlings of the market, which were quality growth, high momentum but expensive stocks with stable earnings and low volatility. Eventually, they underperformed once enthusiasm ebbed and the bubble burst even though they continued to deliver what they had promised. In the end, relative valuation did matter.