October 24, 2021
This newsletter issue takes a look at value stocks compared to growth stocks, and makes an argument for at least a mild resurgence of value performance. It also provides an update on the current inflation situation, particularly for housing.
Value Stocks: Not Quite Dead Yet
Sentiment on value stocks and value investing is still near a historical low point.
With about 90 years of data, value stocks have historically outperformed growth stocks in aggregate, although not in every decade.
In particular, this past 2010s decade has been crushingly in growth stocks’ favor, and it hasn’t been close. The mega-cap internet stocks like Microsoft (MSFT), Apple (AAPL), Amazon (AMZN), Facebook (FB), Alphabet (GOOGL), Netflix (NFLX), Salesforce (CRM) and a host of other growth companies like Visa (V) have been the main drivers of US stock market and indeed global stock market performance, as most value sectors lagged badly and chopped sideways for much of the decade.
That trend differs significantly from multiple previous decades, where an investing approach that leaned towards buying out-of-favor stocks did better. This past decade was a particularly brutal one for value investors, and that fact has been well-known for years.
This long-term chart shows the Russell 1000 Value Total Return index divided by the Russell 1000 Growth Total Return index. When it’s going up it means value stocks in aggregate are outperforming, and when it’s going down it means growth stocks in aggregate are outperforming.
That particular chart relies on FTSE Russell’s metrics for what constitutes a value stock vs a growth stock. In truth, there is no firm definition between the two, other than that value stocks tend to be cheaper, slower-growing companies that often pay a dividend and return capital to shareholders, while growth stocks tend to be more expensive and faster growing, and are still reinvesting heavily into their business.
As the chart shows, 1) value stocks outperformed for much of the 1980s leading into the savings and loan crisis, 2) growth stocks outperformed for much of the 1990s leading into the dot-com bubble, 3) value stocks outperformed for much of the 2000s leading into the subprime mortgage crisis, and 4) growth stocks outperformed for much of the 2010s leading into the COVID-19 pandemic and subsequent fiscally-driven inflationary reversal. The two factors, growth and value, went in big cycles as economic bubbles and monetary policy shifted around and ultimately ended with excesses each time.
Looking back at the past three years, we see that the ratio of value to growth stock performance bottomed in 2020 and started to turn up after lockdowns eased and vaccines were announced. It then had a correction again in 2021 to a higher low, in part due to the Delta variant and fiscal spending slowdowns, but now is now seemingly back in an uptrend with energy stocks and financials holding up pretty well:
I’m watching to see if it holds this trend or not. Recent years have been full of people making “growth to value rotation” calls, but this one has been in place for a while and came with a recession and a rather fundamental shift in fiscal and monetary policy, which is when most major value/growth rotations occur.
If we want to go back more than the four decades that Russell has data for, here’s a great chart. It shows the rolling 5-year return differential between value and growth stocks from the early 1930s to 2020. When it’s green (positive), it means value stocks have outperformed over that period, and when it’s red (negative), it means growth stocks have outperformed:
Chart Source: Michael Lebowitz, Real Investment Advice
Value stocks outperformed during 82% of rolling 5-year periods according to that data set, but the 1930s and the 2010s were major exceptions where growth stocks outperformed by large and persistent gaps.
Anyone who has followed my work for a while knows that I regularly use the 1930s/1940s analogue to describe the 2010s/2020s economic situation, at least in terms of fiscal and monetary policy and the long-term debt cycle. History doesn’t repeat, but it does rhyme. The disinflationary 2010s were very similar in many ways to the disinflationary 1930s, and the inflationary 2020s are shaping up to be similar to the inflationary 1940s.
This is one of the set of charts among several that I’ve used in my research pieces to show the similarities between those two periods:
Some analysts don’t like that comparison, and no analogue will ever be a perfect fit, but I find that it provides tremendous context for understanding this unusual market environment. It allowed investors to anticipate major stimulus and inflation in response to the 2020 crisis. A lot of investors say this type of economic environment is unprecedented, whereas the truth is, it’s just unprecedented in developed markets in our lifetimes. There is historical context for situations like this, and then it becomes our job to find the details for how it differs from those otherwise eerily-similar periods. I can’t imagine trying to make investment decisions in this environment without at least having studied that similar period.
It’s not too surprising that the value/growth equity performance differential shows a similarity between the 1930s and 2010s as well. During both eras, a massive credit bubble popped, and economic growth stagnated for the better part of a decade with interest rates held near zero. Growth stocks significantly outperformed value stocks during those decade-long stagnations, as economic growth was weak, commodity prices were low, bank credit was contracting, and investors piled into whatever growth stocks were available.
In the 1930s, that state of affairs persisted until the early 1940s when policymakers were basically forced by external catalysts (total war) to do massive monetized fiscal stimulus and to hold rates low despite the high inflation that all of this spending caused. Similarly, in the 2010s, that state of affairs persisted until the early 2020s when pandemic lockdowns hit a highly-leveraged economy with millions of people living paycheck to paycheck, putting policymakers in a position to either massively stimulate or watch a widespread debt collapse happen. And just like the 1940s, even as inflation began running hot, policymakers have so far kept interest rates low in the 2020s.
As we head deeper into the 2020s, I do expect value stocks to catch a stronger bid than they did in the 2010s. Much like how they did in the 1940s. There are some headwinds against that idea, like the constant flows of capital into passive index funds that make up a large portion of the equity market. These funds buy based on market capitalization and thus inherently have a large-cap growth momentum strategy. But overall, I think the trend is worth watching to see if it overcomes these opposing forces.
Let’s break down how that could happen. This chart shows the S&P 500 sector distribution since 1975:
Image Source: @Rob_Hager
The energy sector is coming back up off of its lowest-ever 2% contribution to the index, but still remains extremely low at 3%. I think that sector could double to 6% or more over the next decade after a strong period of outperformance going forward, and it will have paid out above-average dividend yields during that journey as well. I wrote about my bullish view on oil and gas this past summer, and indeed this autumn we’ve been seeing energy shortages in Europe and rising energy prices everywhere. I think that trend will have dips and surges but that it will persist deeper into the decade. Materials and financials could each increase by a point or two, and healthcare could certainly represent a bit more more than it does now considering the world’s aging demographics.
In contrast, the technology and consumer discretionary sectors are the growth-oriented areas that could see a relative reduction in weighting into those other areas, mainly due to their valuations cooling off a bit. Technology will obviously be a big part of the future as it always is, but the valuations placed on tech stocks can change over time, and the existing large-cap set of tech stocks are already in their mature business phase (trying to maintain their established moats against competition and regulatory pressure, rather than rapidly innovating, generally speaking). While it’s not exactly a “tech investment”, I continue to prefer a sizable bitcoin allocation over any specific tech stock, and I continue to monitor the rapid innovation in that ecosystem via the Lightning network in particular, as well as other areas of the ecosystem.
Importantly, if value stocks in aggregate do outperform growth stocks (still a big “if” at this point), it could take a few different forms. Both factors could have positive returns, with value doing better than growth. Or the value factor could have positive returns while the growth factor has negative returns. Or both could have negative returns, with the value factor doing less poorly between the two.
I lean somewhat towards the middle option but there is a lot of variance that can happen based on policy choices and other variables. Overall, I like to analyze individual stocks rather than rely on broad growth ETFs or value ETFs, because I want to isolate inexpensive stocks that nonetheless have a relevant product or service that is not being disrupted by new technology.
Lastly, we can separate “cyclical value” from “defensive value” sectors. Topdown Charts has a great chart on this subject from earlier this month, where they classify the energy and financials sectors as being cyclical value, and healthcare, consumer staples, and utilities as being defensive value. The chart compares those two groups separately to the S&P 500. This gives much resolution on how they performed over time:
Image Source: @topdowncharts
Overall, some level of mean reversion from the financial sector and especially the energy sector over the next 5-10 years from this low place interests me as a significant possibility.
Interest Rates and Equity Valuations
A lot of people refer to the US stock market being overvalued. And indeed it is trading at historically high valuations by most metrics. With bank accounts and Treasuries yielding below the prevailing inflation rate for a while, investors have basically monetized stocks and used them as a store of value wherever possible.
The equity market capitalization to GDP ratio, for example, reached record highs in recent years at over 200%. Long-term interest rates are in red, since that’s an important variable as well:
Chart Source: St. Louis Fed
Stock valuations in the United States have benefited from a four-decade long bond bull market (i.e. lower and lower Treasury yields). As bonds offered lower and lower yields, it presented a lower and lower discount rate for valuing companies, meaning that an investor could justify paying up for higher stock valuations, since her risk-free opportunity cost primarily consisted of low-yielding bonds.
And as I described in my summer article on the subject, a period of rising yields tends to hurt growth stock valuations if they start the period at very high valuations. Growth stock valuations have been the primary beneficiary from lower yields.
The 2000 dotcom-bubble was somewhat of an anomaly on the stock valuation vs interest rates chart above, as valuations briefly reached very high valuations even while Treasury-rates were moderately high. That was a particularly excessive period of stock market euphoria. Besides that unusually high valuation spike, we can see on that chart above that the 1980-2020 structural trend was for lower and lower interest rates, and higher and higher equity valuations.
If inflation remains sticky at 3-6% or more for a while, then 10-year Treasury yields could very well try to keep pushing up from current super-low levels. Their yields are currently far below the inflation rate, which has only happened a few times in the past sixty years:
While I don’t think Treasury yields will be allowed by Fed to reach too high (and indeed, I expect negative inflation-adjusted yields for most of the Treasury curve to exist for a long time), I also don’t necessarily think the 10-3 yield curve (the difference between the 10-year Treasury rate and the 3-month Treasury rate) has reached its maximum steepness for this cycle yet:
Chart Source: St. Louis Fed
I don’t have a particularly strong view on where Treasury yields will end up for the cycle (as that is partially a political decision by policymakers). The longer-term story, however, is that global developed market interest rates are around zero and likely can’t go much structurally lower, and are more likely than not to start grinding sideways for a while, and will be negative in inflation-adjusted terms.
A steeper yield curve benefits bank stocks, which also have some of the strongest balance sheets they’ve had for decades (a stark contrast to their balance sheet composition in 2007). And the inflationary conditions that push up yields tend to benefit energy and materials stocks, or even more directly, are often driven by these sectors. These are all value sectors.
Here’s a chart I put together back in May 2021, showing 5-year rolling expansion or contraction in the oil price and the consumer price index over the long run:
On the other hand, high inflation and widespread supply chain problems can hurt the profit margins of many companies, and a higher long-duration Treasury yield, if we get that, would likely put pressure on the high valuations of growth stocks.
Apple vs CVS Health
Apple (AAPL), for example, is projected by consensus analyst expectations to have a lousy forward two years of EPS growth after its monstrous 2021 growth, which makes its current 26x price/earnings ratio and $2.3 trillion market capitalization at least slightly uncomfortable:
Chart Source: F.A.S.T. Graphs
In contrast, CVS Health (CVS) is projected by analysts to have slightly faster EPS growth than Apple over the next two years, but the stock is trading at less than half of the earnings multiple as Apple. I’m not saying they should have as high of an earnings multiple as Apple (or that analysts are necessarily correct about the next two years of EPS performance), but I also don’t think the earnings multiple gap going forward should remain quite as wide as it is.
Chart Source: F.A.S.T. Graphs
One thing I like about CVS is that after their major acquisition of Aetna, they prioritized the company around using those greater total cash flows to pay down debt and improve their financial position. Meanwhile, Apple still has a strong balance sheet but continues to increase its net debt level.
In many ways, Apple already transformed into a value stock, because its growth slowed and it began focusing on financialization. But unlike other value stocks, Apple stock is rather expensive, partly because of the 2020/2021 growth spurt in its earnings, and partially because investors are optimistic on its ongoing shift from hardware revenue to ecosystem service revenue.
Cadence Design vs Enterprise Products Partners
An example I’ve used before is Cadence Design Systems (CDNS) vs Enterprise Products Partners (EPD). It’s one of my go-to examples because they are both very high-quality companies for their industries. Cadence provides software for designing electronic and computer systems, and switched towards a SaaS model that has benefitted them greatly and justified a higher valuation to some extent because the cash flows are more reliable. Meanwhile, Enterprise is a large and diversified transporter of natural gas, natural gas liquids, crude oil, and petrochemicals.
Cadence is expected to have decent growth over the next couple years after a recent multi-year period of rapid growth from converting to the SaaS model, but is already trading at a 50x earnings multiple. That valuation is somewhat of a liability if 10-year Treasury rates ever move back up from current historically low levels. Software-as-a-service companies are very attractive investments and justify high valuations, but even those valuations have a limit when the PEG ratio is 4x or 5x.
Chart Source: F.A.S.T. Graphs
Meanwhile, there is a global energy and petrochemical shortage occurring, and Enterprise has the wide-moat physical infrastructure to transport and export some of these things. It is trading at a historically low valuation and has a historically high (and well-covered) distribution yield of 7%+ that it has grown for 23 consecutive years, while its balance sheet ironically carries a slightly higher S&P credit rating than Cadence has.
Chart Source: F.A.S.T. Graphs
Again, Enterprise shouldn’t have the same valuation as Cadence, but it seems that investors are piled quite tightly onto one side of the ship towards growth here. Going forward when factoring in the distributions, Enterprise is more appealing to me than Cadence in terms of the probability of providing good forward total returns.
Microsoft vs EOG Resources
I’m a fan of Microsoft (MSFT) stock, have owned it for years, and still do. But with a staggering $2.3 trillion market capitalization, and with a price/earnings ratio in the high 30s, it should be quite hard for Microsoft to match its past five years of performance with the next five years, unless consensus analyst expectations are way too bearish:
Chart Source: F.A.S.T. Graphs
Meanwhile, energy producer EOG Resources (EOG) is generating great cash flow, has radically improved its balance sheet to the strongest financial position it has ever been in, and yet its stock price still trades rather cheaply compared to its earnings at current energy price levels:
Chart Source: F.A.S.T. Graphs
The Microsoft/EOG total return performance ratio chart is pretty interesting. It feels like we’ve been here before:
Microsoft radically outperformed in the 1990s up to its peak dotcom-bubble valuation. Then in the 2000s, its valuation popped, while oil entered a massive bubble of its own. After that, in the 2010s, oil entered a long bear market and Microsoft rose like a phoenix to outperform many competitors with a transformation towards software-as-a-service and cloud computing, and it once again crushed EOG in terms of gains, with the performance ratio having an accelerated blow-off top as the stock stocks entered into the pandemic lockdown recession of 2020 and sharply diverged.
But since then, EOG is gaining on Microsoft again from that bubble peak (purple line going down). I still think that trade has more to go in EOG’s favor before the dust settles, even though it could take years to play out.
Overall, these are just some examples of things I’m looking for in the market. The value factor has put in a pretty clear reversal from growth stocks over the past year, but the continuation of that reversal is by no means assured. Comparative valuations further justify an allocation to value stocks, although growth stocks do have a tendency to surprise to the upside, especially in recent years. I like both in my portfolio, but prefer value stocks at current levels overall.
I have several investment accounts, and I provide updates on my asset allocation and investment selections for some of the portfolios in each newsletter issue every six weeks.
These portfolios include the model portfolio account specifically for this newsletter and my relatively passive indexed retirement account. Members of my premium research service also have access to three additional model portfolios and my other holdings, with more frequent updates.
I use a free account at Personal Capital to easily keep track of all my accounts and monitor my net worth.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I put new money in regularly. Currently I put in $1,000 per month.
It’s one of my smallest accounts, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
I chose M1 Finance because their platform is commission-free and allows for a combo of ETF and individual stock selection with automatic and/or manual rebalancing. It makes for a great model portfolio with high flexibility. (See my disclosure policy here regarding my affiliation with M1.)
And here’s the breakdown of the holdings in those slices:
Changes since the previous issue:
I haven’t made many changes to the portfolio recently. I slightly reduced Cameco (CCJ) in favor of some Sibanye-Stillwater (SBSW), replaced Exxon Mobil (XOM) with EOG Resources (EOG), and replaced Home Depot (HD) with PulteGroup (PHM).
Other Model Portfolios and Accounts
I have three other real-money model portfolios that I share within my premium research service, including:
- Fortress Income Portfolio
- ETF-Only Portfolio
- No Limits Portfolio
Plus I have larger personal accounts at Fidelity and Schwab, and I share those within the service as well.
Final Thoughts: Rent and Wage Inflation
Until 1983, the consumer price index included housing prices as part of the basket. Then, housing prices were removed from the index since they are a capital asset rather than a consumer asset, but their influence remains in the index as “owner’s equivalent rent” which is a way to try to quantify the rising cost of shelter without including house prices directly. By extension, this cost of shelter indirectly includes interest rates, since if a house goes up in price but the mortgage interest rate is lower, the monthly payment can remain relatively stable.
Back in summer 2021, I noticed that rent CPI was forming a bottoming pattern, and this is something I’ve been keeping an eye on and reporting on occasionally since then. Here is an excerpt from my July 2021 newsletter:
As we head into the autumn, a third inflation variable to watch is likely to be rent prices. This recent spike to 5.39% official year-over-year broad price inflation occurred at a time when year-over-year rent increases, which are one of the biggest components of the inflation basket, were on the downtrend to below 2%.
Now, however, rent year-over-year inflation is showing a potential bottom:
Chart Source: St. Louis Fed
Owners’ equivalent rent (which is the government’s indirect way to include housing costs in the CPI calculation, without including the home price itself as a capital asset) historically follows the prices of homes with an 18-month lag:
Source: Jeroen Blokland
With the rate of rent inflation seemingly bottoming and rolling up now, with eviction moratoriums coming to an end, and with high housing costs, an uptick in rent and owner’s equivalent rent appears set to provide the next round of overall price inflation to keep the broad CPI number somewhat elevated.
-Lyn Alden, July 2021
Well as of September 2021 data (reported in October), both owners’ equivalent rent and rent itself as part of the official CPI basket have formed a clear trend up in rate of change terms for several months now.
Chart Source: St. Louis Fed
Data from Apartment List suggests that these measures still have some catching up to do against the on-the-ground numbers. They have a great chart from last month showing the pre-pandemic rent price trend vs what actually happened in 2020 and 2021:
Chart Source: Apartment List
During 2020, rent prices were flat-to-down, under their historical trend. Rent moratoriums and considerable economic uncertainty were themes of that year. However, in 2021, rents have sharply risen to levels well above their historical trend.
The combination of rent and owner’s equivalent rent make up about 30% of the headline CPI basket, so this move is meaningful. This is likely to keep headline inflation rather elevated for another couple quarters at least, along with whatever happens with the rest of the basket of goods and services in the index.
This rising cost of housing necessitates higher wages for workers if they are going to keep up with that. This contributes to ongoing labor shortages, and should lead to higher wages, which if companies want to try to preserve their profit margins, means raising prices on their products and services as well.
The Atlanta Fed Wage Growth tracker shows how low wage growth was during the 2010s decade, which contributed to the disinflationary trend of that period. If annual wage growth starts consistently moving over 4% (which is pretty important, considering that official headline price inflation is 5.4%), that should be another contributor to higher consumer prices.
Chart Source: Atlanta Fed
It will be interesting to see how the bond market reacts to that and something to keep in mind when making investment decisions. I continue to view the 2020s decade as likely being a significantly more inflationary decade overall than the 2010s decade, although it won’t be a straight line.