The Case for Value

Transcript

The U.S. stock market has recently produced very strong returns in aggregate, narrowly led by the seven mega-cap stocks known as the “Magnificent Seven.” Driven by the strength of the Magnificent Seven, which accounted for more than 47% of the Russell 1000 Growth Index as of February 20, 2024, growth stocks have significantly outperformed value stocks.

This uneven market advance has many investors wondering if we should expect growth stock dominance to continue or if a broader market rally, led by value stocks, could be on the horizon.

One reason to be skeptical of continued growth stock dominance is the huge valuation gap that growth stocks currently enjoy over value stocks. As of February 20, the P/E of the Russell 1000 Growth Index was 12.2x higher than the P/E of the Russell 1000 Value index, which measures in the 86th percentile of all month-end observations since January 1998. 

However, since this elevated valuation gap has persisted for some time, we should not necessarily expect the gap to mean-revert quickly. But it does indicate that growth stocks currently enjoy high earnings growth expectations, while expectations for value are quite reasonable. Consequently, it will be much easier for value stocks to surprise markets to the upside going forward.

The stark difference in expectations is particularly noticeable at the sector level, where sentiment for financials and energy sectors are notably depressed while technology sentiment is meaningfully elevated. This can be illustrated by comparing each sector’s share of the S&P 500 on a market-cap basis versus on an earnings basis.

As of February 20, financials—which are heavily represented in the value index—accounted for 20% of the S&P 500’s earnings but only 13% of its market cap. Similarly, energy—another sector heavily tilted toward value—accounted for 8% of S&P 500 earnings but only 4% of the market cap. Meanwhile, information technology—which is extremely growth oriented—accounted for 19% of S&P 500 earnings but 30% of the market cap.

Both the financials and energy sectors face headwinds that could be fading over the near to medium term. In the case of financials, a steepening yield curve could drive profits higher if the Fed cuts short-term rates. In the case of energy, peaking oil rig productivity and/or further elevation of tensions in the Middle East could push oil prices higher.

Another potential tailwind for value relative to growth is higher real interest rates. Real interest rates, defined as the rate of interest minus the rate of inflation, were extremely low during the post-financial crisis period from 2008 to 2019, famously known as the “New Normal.” But an examination of history reveals that the near-zero real rates of that period were actually very abnormal. And the dynamics that held rates so low for so long—most notably extremely accommodative monetary policy—appear unlikely to continue going forward.

If real interest rates do, in fact, revert back to normal levels, it would mean both bad news and good news for stocks overall but could favor value stocks.

The bad news is that stock valuations are generally lower when real rates are high. We can see this dynamic at work by plotting the P/E ratios versus the 10-year real rate over that past 10 years. This reveals a fairly notable negative correlation.

But the good news is that higher real rates are typically accompanied by higher economic growth, which in turn should mean higher company earnings. So while the P/E ratio may go down, it does not mean that stock prices need to go down because the “E” could be moving higher. And this could be even better news for value stocks because while P/Es have tended to fall when real rates have been higher, they have tended to fall by much less than growth stock P/Es do.

There is also some good news for growth stocks. Excitement about artificial intelligence has recently made growth stock valuations somewhat impervious to the impacts of higher rates, as investors hold hope that the future earnings boost from artificial intelligence could outweigh the impacts of a higher rate environment.

The bottom line is that while value stocks have trailed growth stocks considerably over the past year, there are reasons to believe this dynamic could shift going forward. As a result, our Asset Allocation Committee has recently moved to an overweight position in U.S. value equities.