In a recent paper, 4 Key Ingredients for Successful Style Investing, OppenheimerFunds Equity Strategist Talley Léger offers evidence on why a regime shift toward value stocks may remain intact even as growth stocks have re-emerged as leaders in 2017. Value stocks began to outperform in the second half of 2016 after a prolonged period of underperformance, but that shift has stalled this year as many of the expectations that market participants started to price into undervalued securities have not yet borne out.
In the short term, we may see growth stocks continue to outperform as investors reassess their expectations for continued positive economic catalysts. Looking ahead, though, we believe investors should not ignore attractively priced stocks as they may offer investors the potential for improved performance, given the current richness of the overall market.
Since the global financial crisis of 2008-2009, interest rates have remained stubbornly low in many markets across the globe. That, along with persistently low economic growth, has caused many investors to direct their attention toward stocks with higher projected earnings growth, as opposed to those with potentially more attractive fundamentals, but weaker growth prospects. Another compounding factor driving investor behavior has been uncertainty about the direction of economic growth and, more recently, about the political environment. Looking ahead, we believe we may not have seen the end of this uncertainty, but we expect investors will eventually refocus on fundamentals and exhibit less sentiment-driven behavior.
One can look at the relationship between the performance of growth and value stocks and the slope of the U.S. yield curve as measured by the difference between 2-year and 10-year bond yields. Exhibit 1 These two measures have exhibited a positive relationship recently with value outperforming growth when the yield curve steepens, as it did in the fourth quarter of 2016. Conversely when the yield curve flattens, as we witnessed in the first quarter of 2017, we have seen value stocks underperform growth. A flattening yield curve often coincides with investors perceiving greater levels of uncertainty, as compared with the more normal steep yield curve, which generally coincides with investors expecting improved economic growth.
What is unique about today’s market is the amount of uncertainty present. Many market observers have noted the current divergence between stock market volatility and political uncertainty, given that historically they have always had a close relationship. Exhibit 2 There is much debate as to why that is the case. Some believe that market participants are missing the bigger picture, as stocks are no longer inexpensive and earnings growth has improved, but remains modest. Others note that the CBOE Volatility Index (VIX), which shows the market’s expectation of 30-day volatility, is low for a reason. That reason is that the reflation trade – the bet that President Trump’s policies would lead to U.S. inflation and growth, and hurt bonds – has not been taking shape since he took office. Bond yields have actually started to move down again and inflation has remained low, especially in Europe.
In this market environment, we have seen strategies focused on stocks’ fundamentals underperform as market participants have rewarded names that were expected to deliver high earnings growth. While some of these stocks may deliver significant growth by continuing to transform and disrupt industries, now may not be the time to continue to bid up these names. Since fall of last year, value has sharply outperformed growth and the revenue-weighted U.S. large cap index, which has a significant value orientation, has outperformed the market-cap weighted S&P 500. Exhibit 3
We continue to believe that investors, over the short term, may need to see greater clarity on the political trajectory of President Trump and the U.S. Congress before they turn their attention to attractively priced stocks. For investors with longer-term horizons, however, it may make sense to revisit strategies that focus on companies’ fundamentals, such as revenue weighting, since they offer an attractive exposure to stocks with strong revenues at inexpensive prices.
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The S&P 500® Index is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy.
The Russell 1000® Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected growth values.
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