Will Tax Cuts (Finally) Reawaken Value?

A sparkler firework and sunset.

If you squint really hard, you can almost see value stocks beginning to stir. Large cap U.S. value has nominally outperformed growth month-to-date. That said, value is still trailing its sexier cousin, growth, by roughly 1500 bps (basis points, or 15%) in 2017.

The question many are now asking is whether that will change if tax cuts are enacted? Given that an untested faith in fiscal stimulus led to value outperformance in late 2016, perhaps an actual tax cut might provide a more durable rally in value? My view is probably yes, assuming you believe that tax cuts will impact the real economy.

Big discount

To start, a bit of history. As I’ve described in previous blogs, years of underperformance have left large cap value stocks historically cheap relative to large cap growth stocks. Since 1995 the Russell 1000 Value Index has typically traded at around a 57% discount to growth. Today the discount is nearly 70%, close to the lowest relative valuation since 2000.

Many would argue that the discount is justified given a wide gap in earnings growth and profitability. Value stocks are, by definition, values for a reason, i.e. they tend to be less profitable. However, even after adjusting for current differentials in profitability, value looks cheap.

Historically, the differential in return-on-equity (ROE) explains approximately 35% of the variation in growth/value relative valuations. Currently, the ROE on the Russell 1000 Growth Index is over 25%, versus less than 10% for the Value index. This spread of 16 percentage points is historically wide, but even that does not fully explain the value discount. If the historical relationship held, value stocks would be trading at around a 62% discount to growth, not today’s historically wide levels.

All of which suggests that value does look too cheap relative to growth. Unfortunately, one could have reached the same conclusion for most of the past three years and still underperformed by betting on value. As discussed back in October, what value lacks is a catalyst.

Term Premium Equity Valuations

A little bit of help from inflation

Tax cuts might provide the missing ingredient. The reason: Typically investors place a smaller discount on value when growth is faster, particularly nominal growth. In other words, a bit of inflation would help close the valuation gap between value and growth.

Looking back at the past 20 plus years, value has traded higher relative to growth when inflation, measured by the consumer price index (CPI), is higher (see the accompanying chart). Higher inflation would arguably be even more supportive if it were driven by higher oil prices, as energy companies appear particularly cheap today. In addition, to the extent higher realized inflation leads to higher inflation expectations—and in turn, higher interest rates—financial stocks, another big value sector, also benefit.

Bottom Line

Tax cuts can provide the necessary catalyst for value stocks, assuming they do more than just boost corporate profitability. In order to really impact style performance, they will need to boost nominal growth as well.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Value: Dead or Just Slumbering?

The Pyramid complex at Giza, Egypt.

Despite stalling in recent weeks, U.S. equities remain at or near historical highs with many indexes enjoying double digit gains. But not all segments of the market have fared so well: Many of the reflation trades that dominated late 2016 have reversed. This has been most evident at the style level.

After a stellar second half of 2016, value stocks have largely sat out this year’s rally. The S&P 500 Value Index has gained roughly 3% year-to-date, a bit of an embarrassment compared to the 15% rally in the S&P 500 Growth Index.

Why has growth done so well while value has barely merited a look by investors? A couple of factors help explain the performance gap.

Mean reversion

While growth has crushed value year-to-date, the one-year performance numbers are more balanced: 9.6% for value and 14.5% for growth. Part of growth’s outperformance year-to-date simply reflects some “catchup” after value’s strong run in the back half of 2016.

Moderating expectations for economic growth

Although the U.S. economy is firm, we’re not seeing the pickup in U.S. growth and inflation that many had expected. Most measures of inflation have decelerated and expectations for economic growth have softened. Based on a Bloomberg survey of economists, 2017 U.S. growth expectations have fallen from 2.30% in February to 2.10% today. This is important as value tends to perform better when economic expectations are rising. In contrast, when economic growth is modest, investors are more likely to put a premium on companies that can generate organic earnings growth, regardless of the economic climate. This dynamic helps explain the strong year-to-date rally in technology stocks.

What could change this dynamic? Two things to watch, the first being events in Washington, D.C. Economic estimates have slipped in part because investors and economists have put a lower probability on tax reform and/or fiscal stimulus. If Congress started to evidence real progress on tax reform, economic expectations would likely rebound along with investor’s preference for value.

If Washington cannot rescue value, eventually investor excess will. When value outperformed in late 2016, it was the exception that proved the post-crisis rule: This has been a growth-led rally. Growth has trounced value since the market bottomed in early 2009. As a result, the relative value gap between the two styles is back to levels last seen at the peak of the late 90s tech bubble.

S&P Value to Growth P/E Ratio
S&P Value to Growth P/E Ratio

Since 1995 the average ratio between S&P Value and Growth price-earnings (P/E) ratios has been 0.45, i.e. value typically trades at a 55% discount to growth. Currently the ratio is 0.30, close to two standard deviations below the long-term average. Value has not been this cheap relative to growth since early 2000.

Relative value is a poor short-term timing mechanism, but at some point investor preferences will shift. After all, this is not the first time that value has been left for dead.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of August 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Why Value Is Still a Value

Cheap, Piggy Bank, Recession.; Shutterstock ID 285751541

For much of the post-crisis period investors consistently craved growth stocks. They did so for the same reason they favored stocks with a healthy dividend: Both income and growth were scarce commodities for much of the past eight years. However, with yields rising and economic growth at least stabilizing, this began to change in the second half of 2016 when classic dividend plays stumbled while value started to come back into vogue. However, these trends stalled in January, raising the question of whether the recent preference for value has further to go. My view is that it does, primarily because value still appears cheap relative to growth.

The notion of the “value of value” seems a bit redundant, but it is important when assessing style preferences. While value stocks, by definition, will trade at a lower valuation than growth stocks, the valuation spread moves over time. Based on the price-to-book (P/B) metric, since 1995, value stocks, as defined by the Russell 1000 Value Index, have typically traded at around a 55% discount to growth stocks.

During the tech bubble growth stocks became more expensive, pushing the value discount to more than 70% at the market peak in 2000. Conversely, prior to the bursting of the housing bubble, it was value that looked expensive. The rally in financial shares, which typically command a higher weight in value indexes, drove the value discount down to around 45% in 2006. The chart below illustrates this, showing the ratio of the value P/B to growth P/B. A relative ratio of 0.55, for example, translates into a value discount of 45%.

Russell 1000 Value Growth

As financials started to come under pressure and the extent of the housing bubble became clear, investors started to demonstrate a strong preference for companies that could grow their earnings regardless of the economic environment. This preference for growth manifested in the outperformance of both stable growers, like defensive consumer staple companies, as well as technology firms benefiting from secular trends. As a result, value has gone from a 45% discount to growth in late 2006 to a 65% discount today.

While value was even cheaper in early 2016, today’s discount still places the growth/value spread more than one standard deviation below the long-term average. In other words, value stocks still look attractive relative to growth.

To be sure relative cheapness is not a guarantee of relative outperformance, but to the extent that value stocks are cheap and the economic outlook is improving, value has a reasonable chance of continuing its run.

For investors, the challenge is that the latter condition, i.e. better growth, is somewhat dependent on whether Washington can conjure up a reasonable and timely stimulus package, including tax reform. A stumble in such efforts is likely to revive old concerns over secular stagnation and push investors back toward old habits, namely a preference for yield and stable growth. However, even a modest package that raises growth expectations stands to benefit the cheapest segments of the market.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Past performance is no guarantee of future results.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of February 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

The Recent Success of Growth Stocks

Growth Value

There’s been a recent divergence in the US stock market. Growth stocks (which are faster-growing companies that tend to have high stock prices relative to the fundamentals of their businesses) have done better than value stocks (which are slower-growing companies that tend to have low stock prices relative to the fundamentals of their businesses) by a sizable amount.

While faster-growing companies certainly sound like they’d be good investments, over the long term it’s actually value stocks that have done better. Yet it’s not unusual for growth and value to have cycles where one substantially outperforms the other for a few years at a time. During the late 1990’s growth stocks surged ahead of value stocks, for example. For much of the 2000’s the opposite was true.

In recent years growth stocks and value stocks had moved almost in lockstep until late 2014, when growth began to outperform. The gap widened in the past few weeks when a number of prominent growth stocks, such as Alphabet (formerly known as Google) and Amazon, reported better than expected third-quarter earnings.

Based on the history of growth/value cycles, it’s very possible that this could be the start of a trend that lasts a few more years. But that doesn’t mean that abandoning value stocks and investing only in growth stocks is a good idea. When the growth/value cycle turns, it can turn extremely quickly. After their success in the late 1990’s, growth stocks came crashing down in the early 2000’s even as value stocks barely budged. After surging in the mid-2000’s, value stocks fell much faster than growth stocks during the financial crisis in 2008.

As is often the case with investing, diversification is probably a better strategy than either only growth or only value. There’s nothing wrong with investing more in growth stocks to try to benefit from periods when they do better, or investing more in value stocks to try to take advantage of their long-term outperformance. But history suggests that having only one or the other can leave your portfolio exposed to extended periods of pain.