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AAM Viewpoints – Value Stocks: Fallen Angels?


After 15 consecutive months of positive total returns for the S&P 500 Index, the honeymoon is over. The January 26, 2018 all-time high seems like a distant memory as tighter monetary policy and uncertain trade relations spurred a market correction and sent investors searching for safe havens. Some havens have performed as expected while several others have not held up as well, especially if you compare them to past corrections. The table below shows selected index performance which details how safe havens have performed over the two most recent corrections.

























































 



Price Return



Index



Current Correction



Previous Correction



 



1/26/18 - 4/6/18



12/29/15 - 2/11/16



S&P 500 Index



-9.34%



-11.99%



SPDR Gold



-1.31%



16.50%



Bloomberg Dollar Spot Index



0.72%



-0.91%



S&P 500 Utilities Index



-1.28%



3.92%



ICE BofAML Treasury Index



-0.20%



4.07%



Bloomberg Barclays US Agg Index



-0.57%



2.49%



S&P 500 Consumer Staples Index



-10.74%



-3.84%



Source: Bloomberg data | Past performance is not indicative of future results.


As you can see in the previous cycle, assets such as Utilities, Treasuries, Corporate Bonds, and Gold posted strong positive gains, while this time around they are all decidedly negative. Furthermore, in a quarter that featured such volatility one might be surprised to see Factor performance for the S&P 500 through the first three months of 2018. According to JPMorgan Asset Management, the characteristics most negatively impacting performance year to date are Minimum Volatility, High Dividend, and Defensive – the exact opposite of what you might expect given the environment.
















































 



Factor Performance



 



12/31/17 - 3/31/2018



Momentum



2.8%



Quality



1.3%



Cyclical



1.0%



Small Cap



-0.1%



Multi-Factor



-0.5%



Minimum Volatility



-1.1%



High Dividend



-2.1%



Defensive



-4.0%



Source: JPMorgan Asset Management | Past performance is not indicative of future results.


What is the one thing these underperforming areas have in common? Most have an income component and therefore are sensitive to changes in interest rates. Keep in mind the yield on the 10-year U.S. Treasury went from 2.40% at the beginning of the quarter, to as high as 2.95% in February, before finishing the quarter at 2.74%. The precarious situation of market volatility in conjunction with tighter monetary policy and rising interest rates has left very few places to hide.


One such place is Value stocks. Despite an economic environment that typically favors the Cyclical Value style (faster economic growth, higher commodity prices, some of the best revenue and earnings growth in years), Growth stocks have continued to outperform. Indeed, Growth is in the midst of an 11-year uptrend versus Value and the pressure on Defensive and High Dividend equities in the first quarter of 2018 (which are almost always Value stocks) has pushed the relative outperformance to a 16.2-year high. The gray clouds of higher interest rates have hung over this space for years. We believe it is overdone and that the Growth/Value relationship is ripe for capitulation.





Source: FactSet Data | Past performance is not indicative of future results.


This time let’s compare style performance of Growth stocks to Value stocks in the current tightening cycle* to the most recent cycle. As you can see below, it is also much different this time around….

































 



Current Cycle



Previous Cycle



Start



12/28/2015



6/1/2004



End



3/30/2018



9/30/2006



Russell 3000 Growth



40.29%



14.01%



Russell 3000 Value



22.39%



38.95%





*Tightening cycle defined as at least three consecutive rate increases without an intervening easing cycle.

Source: NY Fed, FactSet. | Past performance is not indicative of future results.


Taking a quick look at valuations and growth expectations we do not see a substantial reason for the underperformance. In fact, the Russell 3000 Value Index is trading at a discount to the S&P 500 and is expected to grow earnings faster over the next 12 months. 




































Index



P/E Ratio



20 Yr. Avg P/E



Est. EPS Growth



PEG Ratio



Russell 3000 Growth



27.40



25.81



36.48%



75.11



Russell 3000 Value



19.59



18.18



32.10%



61.03



S&P 500 Index



21.47



19.51



29.77%



72.12





Source: Bloomberg data, as of 4/13/18 | P/E = Price/ Earnings; EPS = Earnings Per Share; PEG = Price/Earnings to Growth | Past performance is not indicative of future results.


To be sure, we are not abandoning Growth. As long as the Fed is tightening growth, stocks should be well positioned. With that in mind we do see a tactical opportunity for Value stocks to make up some ground in the intermediate term (6-18 months) as the “Growth Premium” appears to be overextended. According to data from Ned Davis Research, the average length of a “Growth (style) Bull” is approximately 3.2 years – compared to the current run of 11.6 years, the longest on record.


While the volatility that began in January due to the continuation of the tightening cycle has been hard on certain areas of the market, we believe the Fed is raising interest rates for exactly the right reason: the economy is on a solid foundation and able to withstand interest rate normalization. We expect corporate revenues and earnings to continue to grow at a solid clip throughout 2018 which should be supportive of equity prices in general and could ultimately lead to a healthy rotation back into cyclical Value stocks.


 


CRN: 2018-0402-6530 R


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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