Old ideas, challenged
The gyrations of the US market over the past few weeks have provided an interesting insight into investor behavior: particularly when long-held narratives begin to be challenged.
Specifically, the sudden rise in long-term US interest rates has begun to challenge the “lower for longer” narrative that has pervaded investor thinking over the past decade.
The sharp rise in rates coincided with a sell-off of the Nasdaq and more specifically many Technology names that have outperformed over the past year.
This has re-enforced to us the merit in the “tilt” we implemented to client portfolios last year and demonstrates the potential for “value” outperform as market sentiment shifts and old narratives are challenged.
A shift in the collective narrative
We have long spoken of the potential for a rotation into “value” stocks after their decade long underperformance.
This has begun to feed into the broader market narrative.
Expectations are now shifting with regards to future inflation and interest rates.
The post-COVID environment has changed the landscape: an accumulation of savings, pent up demand and strong fiscal support (recently passed US fiscal stimulus bill) are coming to a head with supply constraints and the potential that higher input costs (iron ore, oil) will begin to flow through to higher prices of finished goods.
A corresponding spike in bond yields, fear of inflation and shift in several economic indicators over the last month have caused investors to reconsider their positioning – particularly in “growth” companies that promise to produce the bulk of their cash flows in the distant future.
It is under these conditions that “value” stocks are expected to outperform.
Value’s outperformance? Attributed to two factors.
Expectations that “value” stocks will outperform in this environment are due to two factors.
The first is that as interest rates rise, the value of cashflows in the distant future diminishes. Broadly, the opportunity cost of waiting for these cashflows to arrive is higher, meaning investors are willing to pay less for them.
By this logic, companies that offer cashflows weighted towards the future, i.e., are priced based on the growth of cashflows in the future (or “growth”) would be expected to underperform relative to those that offer cashflows today (or “value”).
The second is the benefits “value” companies may enjoy in a rising interest rate environment.
Long-term bond rates have generally represented expectations about future growth and inflation. Low bond yields represent low expectations for future growth and inflation.
The recent rise in bond yields signifies specific bond market mechanics but may also represent expectations for both higher future growth and inflation as economies recover from the pandemic.
In a world where growth and inflation may be higher than previously anticipated, the promise of future growth in the distant future is less appealing.
The potential for change also favours “cyclical” companies – companies whose earnings are most sensitive to movements in the economy, have pricing power and are generally more capital intensive.
Charting the rotation
A few simple charts illustrate how this dynamic has played out in the US over the last month:
A rotation, not a sell-off: US equal-weighted index vs technology-heavy Nasdaq
The chart below illustrates the sell-off we have seen in the Nasdaq since mid-June (represented by the grey line). As a reminder, the NASDAQ 100 is disproportionately represented by the big 4 technology companies and Tesla (combined approximately 44% of the Index).
We compare this to an index constructed by weighting stocks in the S&P500 equally i.e. each company has equal representation. In this index, each stock accounts for 0.2% of the index irrespective of its size which avoids this issue.
We have written how market cap weighting has resulted in a dynamic where a large proportion of the Nasdaq and S&P500 is invested in technology companies. We can see an equal-weighted index has not seen the same sell-off – on average the share price of companies in the US has risen over February. This shows that selling has been concentrated in certain parts of the market.
The concentration seen in major indices saw a disproportionate exposure to the big 4 technology names which we saw as creating risk.
This reinforces the merit of the “tilt” we made to clients’ international exposure last year – towards a more balanced exposure across countries and within the US.
We subsequently re-positioned our US exposure to be more in line with an equal-weighted index and give a more balanced exposure.
This has seen our US exposure outperform over the past month.
After a multiyear decline, value makes a comeback?
Another way of dissecting the market is to divide it based on simple valuation metrics. Vanguard’s Growth and Value ETFs do this by dividing the market into “Value” stocks - stocks with low price-to-earnings or price-to-book values - and “growth” stocks - stocks with high price to earnings or price to book values (note: a table of the top 10 holdings of each Index is provided below to give a sense of this).
This broadly provides a proxy for comparing the performance of cyclical, capital-intensive companies, with capital-light companies in which the company has priced a lot of growth in the future.
The chart below shows that in the past few months we have seen “value” stocks begin to outperform relative to growth stocks, after a multiyear decline, as prospects of a recovery in growth and higher inflation begin to feed into investor expectations.
The “rotation” we have seen over the past few weeks has highlighted to us how quickly markets can shift when old ideas are challenged.
We see that client portfolios, which have been built with the prospect of change in mind (particularly assumptions around inflation expectations and interest rates), are well-positioned for any change in the existing “lower for longer” narrative, which is increasingly being challenged.
The above market commentary represents the views and opinions of First Samuel Pty Ltd. Such market commentary contains information of a general nature only. Such market commentary is not intended to provide a sufficient basis on which to make any investment decision and should not be taken as such. It has not taken into consideration your objectives, needs or financial situation. Before making decisions in relation to any financial product, you should always obtain and read any relevant Product Disclosure Statement or information statement and seek personal financial advice.