Value stocks are ready for their moment

Good morning. The US stock market ground upwards again yesterday, as it has for most of the past week. And for the past few days, growth stocks have led value stocks, bucking a reasonably consistent trend of value leadership in 2022. Some thoughts on that trend below. Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

Value stocks are good value

Here is a chart Unhedged looks at a lot:

That is the price performance of the Russell 1000 value index, relative to that of the Russell 1000 growth index, on a quarterly basis. Crudely, it shows how cheap stocks have performed against expensive ones. Value did really well, relatively, from the end of the internet bubble to the eve of the great financial crisis. (I worked at a value fund during a lot of that time. It was nice!) It did very badly from the GFC until late 2020, and it’s had a nice little pop this year.

You might look at this chart and think that value has a lot of room to run, relative to growth. But relative price performance by itself doesn’t tell you all that much, and it might not be mean-reverting. Suppose, for example, that growth companies had hugely out-earned value stocks over the past decade. If that’s the case, while value stocks have underperformed, they have not become cheaper in relative terms, and are therefore not ripe for a comeback.

I spoke yesterday with Dan Villalon, a principal at AQR, a large quantitative manager. He suggested a better way to look at growth and value: what AQR calls the “value spread”. This is a comparison of the valuations, rather than the price performance, of growth and value stocks. It gives you an answer to the question: how cheap are cheap stocks, relative to expensive ones?

Below is a crude value spread I constructed. It is the ratio of the forward price/earnings ratio of the Russell value index to the price/earnings ratio of the Russell growth index. The lower the line, the cheaper value is relative to growth. The cycles have often been long, but the value spread has tended to revert to the mean over time:

Value stocks look like a heck of a value right now! Look at it this way. As of yesterday, value stocks have a forward P/E of 13.4, against growth stocks at 22.4. The ratio is 0.57. To get back to the historical average ratio of 0.75, and assuming stable earnings, value stocks would have to rise by about 30 per cent, or growth stocks would have to fall by over 20 per cent, or some combination of both. A little mean reversion here would mean a lot of outperformance for value.

AQR measures the value spread in a more sophisticated way than I do. Below is a chart of their measures of value spreads for US, international developed and emerging country large-cap stocks. In calculating these spreads AQR looks at a range of different measures of cheapness across broad universes of stocks, adjusted for the mix of industries represented in each universe. The values here are standard deviations from the mean. So, for example, valuations of US large-cap value stocks relative to growth stocks are now 2.8 standard deviations cheaper than the long-term mean. That’s a lot!

(Note that their chart is flipped relative to mine: here, the cheaper value is, the higher the line. My way is better.)

A final, interesting point from Villalon. Momentum is a factor, like value, that many investors bet on. Instead of looking at valuation, it looks at price movement. Momentum works a lot of the time. Things that go up (or down) tend to keep going up (or down), often for a long time; the market is not a random walk. Like value, momentum does not work all the time, and historically momentum and value tend not to work at the same time. It makes sense that they would not. Value stocks become value stocks because they are out of favour, their price falling relative to their earnings or cash flow. They have, for a while, negative momentum.

The essence of being a value investor, though, is that you think price can’t fall relative to fundamental value for ever. Eventually, value and momentum coincide, at least in spurts. Now, according to AQR, is one of those moments. Here, using numbers they provided, is a chart of the correlation of the value and momentum factors over time. A value of one is perfect positive correlation, so at 0.26 the positive correlation between value and momentum is not hugely strong — but even that much is rare, especially in recent years:

It is not written in the sky that value and growth are in a mean-reverting relationship, such that value has to recapture the ground it lost to growth in the past decade or so. But there is the simple intuition that value companies are bargains, and bargains eventually become too cheap to pass up. Right now that intuition is winning.

A few more points on capitulation 

Looking back on Wednesday’s comments on capitulation, it occurred to me that there are some important points I didn’t emphasise enough. Here they are:

• I should have made the point more strongly that, judging by flows into equity funds, retail investors have not capitulated. To that end, here is the same chart from VandaTrack that I showed on Wednesday, but going back all the way to 2019, instead of only year to date. The buying that increased early in the coronavirus pandemic simply has not stopped:

  

• Lots of people think that the capitulation that matters most is Federal Reserve capitulation — that is, they think you won’t see the market bottom and recover until the Fed has signalled that it is backing off. One such person is Unhedged’s friend Ian Harnett of Absolute Strategy Research, who tweeted the chart below yesterday, writing “don’t forget one simple fact . . . we need the Fed to capitulate! Bear markets don’t end until the Fed has cuts rates — and usually by a large amount.”

  Now, I’m not sure this cycle will be like previous cycles, but it’s hard to call the bottom when the Fed is still going at 75 basis points a month.

• Speaking of the Fed: the idea that we are anywhere near a market trough is absolutely dependent on the markets being roughly correct about the terminal fed funds rate. The market is very confident that the Fed will be able to stop at about 3.5 per cent. If the real number turns out to be, say, five, the market has to make another big adjustment.

• Finally, if any of us do pick the bottom of the market with precision, that will be luck. The only way to be there when the bottom happens is to start buying slowly as the market falls and to keep on buying. As Rob Arnott of Research Affiliates put it to me this week: “Any good value strategy averages in — it is the only way you can be sure to have peak exposure when the market turns.” 

One good read 

Alan Blinder makes the case that the Fed should move slowly.