The 2019 stock market rally continued in the second quarter, with the S&P 500 tacking on another 4.3%, giving the S&P a 18.5% return for the year. With earnings tracking to a modest 2.6%[i] growth rate for 2019, this gain is mostly due to the Price/Earnings multiple expansion. The market is clearly more expensive today than it was at the beginning of the year. At the current forward P/E of 16.9, the market is trading slightly ahead of the 10- year average of 14.8. A major reason for this is the Federal Reserve changing course and pumping liquidity into the market by signaling their openness to lower interest rates. As the 10-year bond yield has dropped from 2.6% to below 1.9%, the options for investment returns have shrink in the bond market, pushing investors into other areas, including the stock market.
Growth has outperformed Value
All stock sectors though are not benefiting equally. We have seen tremendous divergence between value and growth stocks with growth trouncing value. Over the last 5 years, the Russell 1000® Growth Index beat the Russell 1000® Value Index by almost 6% per year (13.4% vs 7.5%). Much of the market history have favored the exact opposite. For the prior 19.5 years, value outperformed by over 1.5%/year (10.5% vs 8.9%). [ii]
What has caused this notable performance change in Value versus Growth? In a recent report from Ned Davis Research[iii], they point out how a number of reasons for this. First, the mere fact that value had historically outperformed had market participants overweight in this direction. This may had led to over-valuations in value stocks, in effect, removing the advantage. The second is somewhat counterintuitive. They have found that value stock outperformance requires a stronger growth economy. Growth stocks can grow regardless of the underlying economy, while many value stocks need a booming backdrop to succeed. This makes sense for banks, which require a decent spread between short-term rates and long-term rates, typically happening during booms. Another value sector, commodity-based companies earn excess profits when material shortages occur, also typically in a bustling economy. Since the end of the financial crisis, the economy has been slowly and steadily improving, not quite reaching the “escape velocity” that value stocks need.
When will Value be Back in Favor?
The fact that the market has rewarded growth for an extended time may not indicate it is changing any time soon. This is, in part, due to changes in our economic cycles. As the economy has shifted from manufacturing to consumption, the economic cycles have lengthened due to the more stable consumer spending pattern versus shorter manufacturing cycles. Even with the long period of growth, the Federal Reserve is still pumping the economy with low rates and expectations are for even lower rates in for the next few years. In their report, Ned Davis points out 12 Indicators which help them to determine which indicators are pointing to Growth or to Value and only 2 are leaning toward Value versus 6 for Growth (4 are neutral). Furthermore, they argue that the biggest driver of a switch is the economy reaching escape velocity. Therefore, with the Fed still needing to help the economy, they see this trend continuing.
Here at APG Capital, I see reasons to be cautious, namely valuations are elevated and significant political risks. We are favoring a modest underweight to equities, but within our equity allocation we are sticking to a growth theme as these companies continue to disrupt industries.
APG Capital Asset Management recently hit its 2-year anniversary and we are so thankful for the continued trust and confidence of our clients.
[i]https://www.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_070319.pdf
[ii] https://indexcalculator.ftserussell.com/ICStep4DR.aspx
[iii] Clissold, Ed, “US Featured Report: Will Value ever outperform again”, Ned Davis Research, May 30, 2019.
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All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. Indexes are unmanaged and do not incur management fees, costs, or expenses. It is not possible to invest directly in an index. The information and material contained herein is of a general nature and is intended for educational purposes only. This material does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities. The future performance of an investment or strategy cannot be deduced from past performance. As with any investment or investment strategy, the outcome depends upon many factors including investment objectives, income, net worth, tax bracket, risk tolerance, as well as economic and market factors. All economic and performance data is historical and not indicative of future results. All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed.