What’s Cheap? (Don’t Answer That. It’s A Trick Question)

What’s cheap in equities?

Wait. Don’t answer that. It’s a trick! It’s all expensive.

I jest. But not really. It is all expensive. Or mostly all expensive. Assuming you’re looking at absolute valuations.

“It’s all relative” has been the mantra for equity bulls for quite a while. Between that creed and “TINA” (“there is no alternative”), you can always conjure a reasonably coherent and halfway convincing case for stocks, even as they trade at higher and higher multiples.

In this environment, it’s understandable that a swift backup in rates has caused considerable consternation.

While the rapidity of recent rate rise has given equities pause, analysts are still loath to suggest that stocks can’t stomach what, historically speaking anyway, are very low yields.

“We believe equity valuations should be able to digest 10-year yields of roughly 2% without much difficulty,” Goldman’s David Kostin wrote late Friday, underscoring points he’s made repeatedly of late.

Beyond the generic question of how far yields would need to rise to derail stocks across the board, a (slightly) more nuanced inquiry is whether the rotation away from secular growth favorites and pandemic winners in favor of cyclical value shares that benefit from economic momentum, reflation, and a steeper curve has overshot in the near-term.

Kostin captures the debate. “Our sector-neutral long/short growth factor declined by 12% during the past month, the largest 1-month decline in its history since 1980,” he said, in the same note, adding that “although the four-month stretch of Value factor outperformance since the vaccine efficacy announcements in November matches the average length of Value rotations since the Financial Crisis, the factor’s 30% recent rise rivals two of the decade’s largest Value rallies, in 2013 and 2016.”

Indeed, the rally in banks and energy (for example) has gone parabolic since the election, making big-cap tech a pitiable laggard, an unfamiliar position for the Nasdaq 100 to be sure.

It’s certainly tempting to say that isn’t sustainable. Indeed, if you’re talking about “old” energy, it’s literally unsustainable.

And yet, as noted here on Friday afternoon, we’re nowhere near wiping away years of outperformance from secular growth. A long-term chart of, for example, the Nasdaq 100 versus the Russell 2000 (or the Nasdaq 100 versus the S&P) suggests the reversal not only “has legs” but could persist almost indefinitely, assuming the macro regime unfolds as many expect.

I’ll use the same chart I often employ to illustrate the point. The figure (below) shows just how far behind value really is.

Getting back to where things stood a decade ago would require a complete collapse in relative performance from growth.

As Goldman’s Kostin pointed out, “at a factor level, ‘Value’ still looks very attractive relative to history.” In fact, if one looks at the gap between P/E multiples for the highest valuation and lowest valuation stocks in the S&P on a sector-neutral basis, the premium was 231% at the beginning of this year, on Goldman’s numbers. That was the highest since the dot-com days (figure below).

Kostin wrote that although “the spread has since declined to 161% [it’s] still substantially above its 40-year average of 103%.”

From where Goldman is sitting (so, at home, with everyone else, until herd immunity), value can continue to outperform with rising rates and better growth.

As for energy and financials specifically, they may have further to go, despite the runaway gains shown in the second figure (above). Goldman sees Brent at $75 next year and Kostin on Friday evening noted that “energy is also the only S&P 500 sector with short interest above its historical average.”

Meanwhile, financials obviously track yields, and while Goldman admits they’ve “rallied more than [the] typical relationship with rates would have implied,” the sector is still cheap on a relative valuations basis if history is precedent.

Coming full circle, it’s still hard to escape the reality of an expensive market on an absolute basis. Goldman doesn’t dance around that. “In some sense valuations today are even more elevated than they were in 2000,” Kostin remarked. “20 years ago, the aggregate S&P 500 P/E was a similar 24x, but the median stock traded at 14x. Today, the median firm trades at 21x,” he added.

Remember: It is possible for two things (or more than two things) to be expensive simultaneously.