One of the (many) pressing questions coming off a fraught (or exhilarating, depending on how you want to look at it) first quarter, is this: What will become of the equity rotation?
As bond yields rose and growth optimism proliferated, pandemic winners and stay-at-home favorites became laggards and otherwise underperformed. Or, worse, they morphed into outright losers.
While not all perennial market favorites from the “slow-flation” macro regime were bludgeoned during the pro-cyclical rotation that kicked into high gear following the election, the Nasdaq 100 did fall into a correction during the first quarter and some manifestations of “froth” encountered the bear.
Read more: The Hubris Bear Market Has Arrived
Obviously, the fate of secular growth hangs at least in part on the trajectory of any further backup in yields.
For example, tech’s correlation with 10-year yields in the US was among the most negative in two decades (figure below) at one point last month.
“Especially in the US, there has been a large increase in equity duration with a larger weight in secular growth stocks – those could face a larger drag from higher yields as they benefit less from reflation,” Goldman said, in their latest asset allocation piece.
The bank’s Christian Mueller-Glissmann noted that “the beta of Nasdaq and MSCI World Growth to US 10-year yields has turned deeply negative YTD.”
I doubt I need to further emphasize this (and I don’t mean to rub salt in the wound for anyone who stuck with a tech/growth tilt despite the demonstrable shift in the macro winds), but small-caps beat the Nasdaq 100 by a country mile during the first quarter (figure below).
Indeed, Q1 marked the first time in five years that the Russell 2000 beat the Nasdaq 100 for two consecutive quarters.
Additionally, it was the first time in quite a while that small-caps beat big-cap tech by a double-digit margin two quarters in a row. (The Russell did correct towards the end of Q1, which makes this all the more indeterminate going forward.)
Similarly, value logged a second straight quarter of outperformance versus growth (figure below).
Note how egregious value’s underperformance was during the depths of the pandemic lockdowns and also over the course of the summer 2020 tech melt-up. That suggests there’s still quite a bit of catching up to do, and that’s to say nothing of all the ground lost over what seems like an eternity of underperformance.
Value has spent so long underperforming that some investor cohorts can’t possibly remember a time when growth shares were out of favor. Let’s say you’re 22 years old. You were a toddler (literally) when the tech bubble burst. I reiterate that at regular intervals, mostly because it’s funny.
The updated figure (below) shows how the tail end of a long, painful bad dream for value crescendoed in a parabolic nightmare during COVID, as growth’s outperformance accelerated at an almost unthinkable rate.
Finally, after the election, the trade tipped over under its own weight.
The future for the pro-cyclical rotation depends heavily on the economic outlook and, by extension, on progress towards herd immunity. If you’re curious as to whether there’s still value in… well, in value, SocGen’s Solomon Tadesse reckons there is.
“Reflecting years of disappointing performance, value’s valuation has touched historical lows in the wake of the pandemic crisis, presenting an unparalleled bargain to investors,” he said, in a new note, adding that on the bank’s composite measure of valuation, US value “was trading at a valuation discount of close to 60% vis-à-vis the broad market at the bear-market bottom in March 2020.”
Even after the recent rally, value was still trading at a 51% discount as of the end of Q1 on SocGen’s metric.
Relative to its own history, value “currently trades at an 11% discount [and] is as attractive currently as it was at the depths of the 2008 Financial Crisis when it was trading at a 12% discount,” Tadesse went on to say.
In remarks to Bloomberg last week, Adam Phillips, managing director of portfolio strategy at EP Wealth Advisors, said he sees the rotation continuing. “Moving forward, it’s going to be more about the recovery plays, and that’s not a story that’s going away,” he ventured.
Knock on wood.
By any historical measure, the PE on many of these stocks had crossed over into “what are you smoking” land. Which is not to say that they are bad buinesses or companies, only that they were — and are — too richly valued in terms of their future growth prospects.
Think not just “value” but the components, which I empirically but unscientifically think of as:
– “Recovery” names that were hit hard by Covid, plunged to low valuations by some measures (not P/E or P/S, but P/outyearE, P/preCovidS, DCF, etc. These names have rebounded a lot but in some cases have a good bit (20-40%) left to go. However, most of these trades are, I’d suggest, going to be ripe to exit by 2H or late 2021. Sell the news, etc.
– “Cyclical/Industrial” names that were sometimes hit by Covid and sometimes not, but anyway didn’t enjoy the Pandemic Party and aren’t Sexy Techy, so their performance lagged a lot in 2020 and perhaps in previous years too. Some of these had strong 4Q20-1Q21 performances, others have been slower to turn up. There are a lot of attractive-looking buys here. Note that many of these are very good, world class companies – yes, it’s possible to be an excellent company without being a groovy Tech name. And many will benefit directly from the global recovery and the US Build Back Better initiatives,
– “Small Cap” names that, aggregated to the Russell 2000, at one point barely equalled the market cap of AAPL. The long underperformance of small cap, the pattern of small cap outperformance at the start of a new economic cycle, and all the buying of small cap names that can be funded by just modest sales of the mega-names, all drove the RUT outperformance, and I’d suspect it’s not done. Add the prolific opportunities for stockpicking in these names, and it makes for good fun, in my opinion.
– “Traditional Deep Value” names that fit the screens of low price/book and other old-school valuation metrics, NOT adjusted for changes in the economy, accounting, and the basic value creation drivers that have happened since Graham & Dodd. I have little interest in this group, other than using P/B in screens. I don’t think that “book value” is a reliable predictor of a company’s future cash flows, returns, margins, growth, upside surprise, positive revisions, or anything that I care about. I think it often means only that a company makes low profits from an asset-heavy model.