Welcome to Finance and Fury. Time for value? Looking at the value rotation occurring within the share market

  1. A value rotation is a term used to describe a shift in investment behaviour – where investors start favouring value shares instead of growth shares
  2. Previous episode – inflation expectations and what is occurring to bond yields – did an episode a while back on why growth shares have been beating value – however a rotation may be occurring – where value investing may start catching up in performance
  3. Value investing – buying undervalued companies based around their intrinsic or book value – essentially involves buying beaten-up or unloved shares
    1. Over the past half decade – growth shares have been in high demand – hence they have seen their prices go up – blowing metrics like PE ratios through the roof – but this has left large segments of the market untouched and undervalued compared to their growth counterparts
    2. Over the past three months – essentially since the start of the year – the mood of the market has shifted dramatically – which may be pointing towards growth shares falling out of favour
  4. This is because the prices of many large growth companies have been falling from their previous highs
    1. Looking back on the past 3 months – the best performing investment have been the US Russell 2000 mid cap index at a 35% return since the start of the year, so under 3 months in reality – EU shares have also done well – with returns on average of 20% over this time period
    2. However – tech has started to lag behind – the returns for this traditionally growth basket of shares is sitting at 15% – this is still phenomenal though – a 15% return in 2.5 months is a good result
    3. But why the lag? This group of shares was the cream of the crop – and in the words of House of Pain – rose to the top – so is it that the rest of the market is now just playing catch up, or is there really a value rotation going on?
  5. Well – yes – there has been a rotation from growth shares into value companies – hence this lag in tech companies in the past 2.5 months – but the key question is ‘Will this continue?’ or in other words, was this movement just a chance to buy neglected shares within the market, pushing up demand and their prices, or the emergence of a longer-term trend? And if so, for how much longer?
  6. So, in this episode, we will be trying to answer this as well as what would drive the rotation going forward?

To do this – we need to look at the state of the market and forecasts – Strong economic growth predicted in 2021 – and beyond

  1. the global economy looks set to boom in 2021 – this has been due to the anticipation of the initial hit of stimulus –
    1. Think of it as energy being introduced into a system – if you have a lot of glucose, or sugar, you can get a bit of an energy high – but this energy can soon burn out
  2. When looking at the underpinnings of growth predictions in 2021
    1. At the moment, massive levels of fiscal and monetary stimulus have been brought to bear on the global economy
    2. Levels as a percentage of GDP not really seen since the world wars in government spending – but what is different is that governments are already starting off at a very high debt to GDP level – based around economic theory, technically has less bang for your buck
      1. Looking at the US – post WW1 – there was debt of around $17bn, 16% of GDP – then by the start of the great recession and the introductions of the New Deals by FDR – this rose to about 42%, or $40bn, by the end of WW2 was sitting at about $270bn, or 118% GDP
      2. By 2020 – debt was $23 trillion and 110% of GDP – now it has jumped to $27 trillion as an estimate and 136% of GDP
  • Now, the US is about to enact a US$1.9 trillion package on the heels of the US$900 billion program just passed in December last year – will mention that the majority of these packages have nothing to do with relief for Covid affected businesses or people – but the market has responded positively
  1. On top of this, the Federal Reserve did as much quantitative easing in six months last year as it did over the initial six years from its implementation in the post-GFC measures – i.e. from late 2008 through to end of 2014
  2. Other countries across the globe have also been aggressive with their policy stimulus in 2020 – in Aus we have gone from 46% debt to GDP to an estimated 70%
  3. Australia has started to engage in QE – and this is beginning to ramp up as well to help keep bond yields in the target range close to the cash rate of 0.1%
  1. The result – investors and markets became bullish – this has become well known – growth shares did very well based around lowering interest rates, funding costs, and lower inflation
  2. The outlook for 2021 is considered to be strong – there is a consensus view amongst economists – so take that with a grain of salt – what is now more critical is whether this strong growth momentum can continue beyond this year once the stimulus expectations are priced into the market – then, how strong will growth be in 2022, 2023 and beyond?
  3. Because what will happen post 2021 once the initial stimulus hit fades – or when the sugar high of the stimulus begins to fade?
    1. What will be left to drive the global economy forward from 2022 onwards? It is always possible that MMT emerges further and regular deficit funded stimulus becomes the norm – but this factor is unknown – so are there any signs of real economic recovery? If so – and importantly for this episodes topic – how would markets behave?

To best answer the question of a value rotation – look at if the growth frenzy is likely to continue and if not, value may be in the markets favour

  1. Thinking about this – one of the big drivers for growth has been the lowering of interest rates and positive reaction to additional stimulus –
    1. But with the yield curves starting to steepen, this has been pointing to the potential for increasing interest rates in the future – beyond 2024 – but markets are forward looking – trying to price in all future events today
    2. When interest rates change – in theory at least, the way companies are valued changes – as mentioned in previous episodes – this rate is heavily tied to the discount rate which is used to get the present value of a companies future cashflows –
      1. I.e. what are the profits of a company worth today
      2. The lower the discount rate – the less a dollar today is worth compared to a dollar tomorrow – so if a company is a traditional value business – with solid cashflow performance and profit stability/predictability today – the less this is worth to markets – so if you are a growth company if you don’t have any dollars today, the market doesn’t care as much
  • The higher the discount rate – the more a dollar today is worth more than a dollar tomorrow – so the fair value of a company should in theory reflect their profits today more so than their profits tomorrow
  1. Therefore – the higher the discount rates, the more a company with strong fundamentals should be worth – indeed – over the past few months as the yield curve has steepened – we have seen value shares have started to outperform growth
    1. the lowering of interest rates may not be possible from here, and yields on the RF may continue to rise further – so can value do better?
    2. To look at this – there are a few primary factors that are coming together which could help to provide continued momentum towards value companies once the initial “sugar rush” stimulus wears off.

Those factors are as follows:

  1. Households have paid down considerable levels of debt in 2020, have higher savings, and have a greater capacity to spend
    1. US credit card balances are down US$120 billion from their peak at the end of 2019 – potentially frees up borrowing capacity which can be tapped into to drive further consumption growth – but also frees up cashflow that goes towards debt instead of consumption
    2. looking at households and consumers – in most countries savings rates have gone up significantly – natural response
      1. In the UK – Q2’s household savings ratio was 26.5% – almost twice its highest peak in the past 50 years – next quarter it had dropped but still around 16.5% – estimated that the extra cash in their bank accounts is around 7.7% of GDP
      2. In the US – equivalent figure is approx. $2.3 trillion or around 11% of GDP – more than doubled in 2020
  • In Australia – jumped to 22% by July 2020 but has declined to 12% approximately last quarter
  1. This technically means that there is less spending going on – if savings rates are up – but as confidence comes back to consumers, and job security increases, saving rates may decline further and help economic growth
    1. Especially if interest/cash rates remain low – no incentive to save beyond the concerns of losing an income
    2. So real economic growth may emerge, as more businesses are allowed to open and operate again
  2. As the economy’s confidence normalises – can be expect the Western consumer will resume their high marginal propensity to spend
    1. That effect, coupled with falling household savings ratios has the potential to provide a strong underpinning to consumption growth through a multiplier effect
  3. The trend of house price growth may remain strong – increasing equity and the wealth effect
    1. Housing markets have maintained prices and grown through 2020 – due to lowering supply – less houses being listed in conjunction with lowering interest rates, increasing borrowing capacities –
    2. After an initial one- to two-month wobble in house prices at the height of the lockdown – most countries’ prices resumed a strong upward trend for the remainder of 2020
      1. This price growth reflects monetary looseness, i.e. the lowering of interest rates, increased liquidity in debt markets and other demographic factors – being in lock down and wanting more space – spreading out as if you are working from home, you don’t want a roommate walking behind you in the nude on zoom
    3. Economists believe that the uptrend in house prices has been historically associated with the wealth effect – where the more people feel wealthy and have access to equity (through a withdrawal from what is in their houses) – this can support strong consumption growth – in 2020 home equity withdrawal has picked up sharply – but it depends on where this money is spent
      1. Also as another note – there are mixed theories on the Wealth effect – in theory it should work, but it doesn’t show any causal relationship
    4. Either way – the underpinning of an increasing yield curve, repayment of debts, ability for additional spending and a strong housing market these can point towards some better growth in the markets – plus, global monetary policy should remain loose for a while yet – forward guidance that cash rates will essentially be 0% for the next 3 years
      1. The major concerns for markets at the moment are the removal of monetary accommodation later this year – the CBs will be walking on eggs shells when it comes to removing monetary measures

Looking at the end effects on markets –

  1. If all of these factors play out – there is likely going to be a structural shift into value and cyclical shares
  2. This expectation can be backed up by the relative valuation between the growth and value indexes – showing the relative valuation premium of growth over value stocks
    1. Going back to 1970s – the premium in price that you are paying for a growth company is at the highest it has been by a narrow margin – the next two were the dot com bubble and the nifty-fifty bubble – that has a lot of similarities – probably do an episode on this
    2. DotCom bubble – paying about a 45% premium for growth, about that in 1975 but close to 58% today – looking at the forward PEs – sitting at about 47% today, which matches the dot com bubble – but not quite as high as the nifty-fifty bubble

Risks and downsides –

  1. Naturally – there will always be multiple risks investing on shares and betting on one outcome over another
    1. The major risks to the market at this stage are downgrades in Central Banks intervention in markets – especially the Fes given the high valuations in many sectors of the equity markets
      1. The S&P500 is on a 12m forward PE ratio of approximately 23x – only been surpassed during the Dot com bubble
      2. not just the US market which is expensive – around 30 indexes across the globe that are in their top quartile valuation range – Brazil, India and the Australian markets
    2. At this stage – liquidity with QE has been a key driver of high valuations – but this may also lead into additional inflation which could require CBs to act – but regardless – if markets crash, being in the value companies may be the place to be 

Summary

  1. At this stage of the market cycle – investors probably shouldn’t be paying as much of a premium for growth because it could be likely that the valuation gap between growth and value shares is on the move to close –
  2. I always have growth and value – in different segments across different markets – but if you are concerned about market downturns – value is the way to go – opportunity to buy into the undervalued companies
  3. Plus – can help to limit downside risks – look at the nifty fifty bubble from the 70s to see why

Thank you for listening to today’s episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/

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