Value Isn't Dead, But No Sector Is Ever 'Due' For a Rally
Depending on who you ask, value stocks are set to soar….or dead as a doornail. Value’s tub-thumpers say growth stocks’ decade-plus dominance can’t endure—particularly with value’s penchant for zooming early in bull markets. Disbelievers argue Big Tech’s supremacy alongside private equity and indexing’s rise seal value’s casket. Wrong and wrong. Value isn’t dead. But the 2020 bear market’s peculiarities make a near-term comeback unlikely. Here’s why.
This winter’s downturn struck lightning-quick—highly unusual for any bear market. They typically start with a whimper, not a bang. Relatively gradual early declines fool greater-fool investors into holding on or buying more—thinking it’s their opportunity to “get in and buy the break.” Later the real sharp plunge happens, whacking late-stage buyers. Not this time. The 2020 bear market struck with the economy on solid footing, corporate profits climbing after last year’s brief “earnings recession” and no real euphoria--that typically dooms bull markets. But when governments suddenly locked down economies to stem the coronavirus’s spread, stocks had to urgently pre-price recession uber-fast. World stocks plunged from all-time highs to bear market territory in 20 trading days—record time. While its magnitude (-34% peak to trough) and fundamental cause made the downturn a bear market by definition, the sudden, panicky plunge functioned more like an oversized bull market correction.
These correction-like features put value out of favor. They distort the credit cycle that fuels value’s usual early bear market outperformance. Typically, as economies surpass prior heights, central banks shift focus. Corralling inflation—not fostering growth—becomes their focus. They tighten monetary policy but inevitably overshoot. Short-term interest rates surpass long rates, inverting the yield curve. Banks—which profit by borrowing short term, lending long term and pocketing the spread—lose incentive to lend much. That tighter resultant credit signals economic contraction ahead. Stocks begin pre-pricing that recession, and a bear market slowly starts grinding lower.
Small value firms—lower quality and typically much more leveraged and higher credit risks than bigger, growth-oriented stocks—get clobbered as that downturn wears on. Banks won’t lend to them—too much risk for too little reward. Instead, they call loans back. Painful months pass. Prior to 2020, post-World War II US recessions averaged about a year, about half longer. Shares plummet as fears mushroom over small value firms’ very survival. Some do fail. But eventually and inevitably, panic causes stocks to overshoot to the downside. Expectations fall too far. Central banks correct course, cutting short rates—usually by more than market-set long-rates fall, steepening the yield curve. Markets then anticipate wider credit spreads spurring lenders to warm to riskier firms. Deeply depressed small value stocks surge after months of misery on expectations of a credit lifeline.
Not this time. While the US yield curve flirted with inversion in 2019, it wasn’t because the Fed raised rates to quell inflation. Instead, long rates sank. Besides, the inversions were tiny—and likely offset by banks’ ability to borrow abroad even more cheaply. Banks’ huge cash stockpiles further put a lid on customer deposit competition, so lenders’ actual funding costs sat well below short rates. No big lending contraction came.
Instead, economic shutdowns meant to slow COVID-19’s spread triggered the recession and bear market. The downturn’s correction-like speed meant small value stocks didn’t suffer the sustained beating that typically tees up their early bull market surge—and current conditions bode ill for them zooming any time soon. From this year’s March 23 low through August 31, global small value’s 51.3% return slightly trails the world’s 54.5% and lags far behind global large-cap growth’s 67.6%. Why? Partly because central banks’ massive quantitative easing programs depress long rates, flattening the yield curve and preventing the bank based credit boost value firms need…..to trigger stock market outperformance on any sustained basis.
Then, too, other factors conspire against value stocks now. In my July 10 column, I noted the turbulence facing the small-cap-dominated Airline industry. Tight credit spreads also weigh on profits of Banks and many other Financials—classic value plays. Oil supply gluts limit upside for the value-heavy Energy sector. Tight credit makes small oil and gas firms particularly vulnerable.
With short rates pinned low, a meaningful credit boost requires strong inflation to juice long rates—not likely anytime soon. The money supply surged after the Fed’s moves this winter, but velocity—the rate at which money actually changes hands—plummeted. Absent a big boost in velocity, the inflation needed to lift long rates and spark a credit kick-start won’t come.
Remember: Value and growth leadership doesn’t change because one style is “due.” Nothing is ever “due.” Nor does one or the other “die” from being out of favor. Growth/value leadership shifts when fundamental drivers impacting companies’ outlooks change materially. Understanding that value stocks are unlikely to soar without a big credit boost gives you an advantage over those who see an imminent rebound—and those who think one will never come.