For the fifth consecutive quarter major stock markets posted positive returns. This string of outperformance began immediately after the pandemic-induced market correction in the first quarter of 2020. The difference in the performance of the most recent quarter compared to the previous four quarters was asset class leadership. From August 31, 2020, to March 31, 2021 value stocks (Russell 1000 Value Index) outperformed growth stocks (Russell 1000 Growth Index) 26.17% to 7.19% respectively. During the three months ending June 30, 2021 the “script flipped.” Growth outperformed value 11.70% to 5.21%, with the Russell 1000 Growth Index (11.70%) as the best performing index of the second quarter. The NASDAQ (also a growth index) was nearly as impressive with a 9.68% quarterly return. The S&P 500 was up 8.55%, followed by the Russell 1000 Value Index (5.21%) and the Russell 2000 Small Cap Index lagging behind at (4.29%).
For many investors, this change in market leadership (value to growth) is viewed as a permanent asset rotation that will continue unchallenged. However, this is a dangerously incorrect assumption as there is emerging evidence the stock market is in the early stages of a prolonged value rally. Pro-growth investors are currently experiencing recency bias. Understandably so, given that large cap growth stocks have outperformed for the last thirteen years. However, fundamental analysis does not support the likelihood of a sustained growth stock outperformance. What happened in the second quarter (growth outperforming value) is temporary. A long-term run by growth stocks is incompatible with basic financial analysis. Examining the Price-to-Earnings (P/E) ratio of each index tells much of the story. The 27 year (entire life of the Russell 1000 indices) average P/E for large cap growth stocks is 25.18 times and 17.12 times for large cap value stocks. Currently the large cap growth stocks have a P/E of 39.63 times (nearly 14.5 points higher than average) and the large cap value stocks have a P/E of 21.3 times (only 4.18 points higher than average). The P/E of 39 times in the Russell Large Cap Growth is the highest since the index was at 42.32 times on December 31, 2000 (pop!).
Examining asset class returns also appears ominous for large cap growth stocks. During the 27-year existence of the Russell Large Cap Growth and Value Indices, the returns of the two are similar. Since inception, the Russell Large Cap Growth Index has annually returned an average of 10.98% while the Value Index has averaged 9.61%. However, the periods of outperformance are distinctly different for each index. During the first 13.5 years (1994 to 2007) of the two indexes, the Large Cap Value Index returned an average annual return of 12.06% while the Growth Index returned 8.95%. In the last 13.5 years (2007 to 2021) the Large Cap Growth Index has achieved an annualized return of 13.05% to Value’s 7.22% during the same period. If the market reverts to the historical mean for each index, we are likely in for a sustain period that significantly favors value.
Looking Forward –
There is no shortage of news and issues to grab investors’ attention. This is the new normal and it remains critical that financial advisors and money managers accurately parse the material from the non-material. The most material economic development is that the U.S. economy is expanding and not contracting. This should be welcomed news to all investors. Stock investors should see increasing equity prices and bond buyers should begin to receive higher yields. All investors must accept that stock markets are volatile and negative quarterly returns will occur. As investors we happily accept the short-term declines for long-term gains.
There are three very important concepts that financial market participants must embrace to continue experiencing financial success.
- Understanding How Stocks are Valued – The stock market is a forward-looking pricing mechanism. The opportunities for out-performance exist in companies, sectors, and industries that will be prospering 12 to 24 months from now. Investors making decisions based on current observations will be left behind.
- Inflation – The U.S. is experiencing higher prices, rising wages, and increasing cost of raw materials. This is inflationary. Inflation is fine for investors. In fact, inflation is exactly why we invest in stocks (maintain purchasing power and standard cost of living). The pitfall for investors is redeeming stocks for cash balances to avoid inflation. Absolutely the wrong approach.
- Do Not Invest Using a Rear-View Mirror – There is a reason every investment opportunity contains the disclaimer “recent results are no guarantee of future success.” The reason is that what worked during the previous period may not work as well going forward. New investors should be especially careful making allocation decisions by looking only at the previous 10-year return results. An analysis of future opportunities will prove to be much more valuable.
There may be no simpler investment adage than “buy low and sell high.” Executing this adage is highly correlated to investment success. However, human nature strongly favors “buy high and hope to sell higher so you don’t miss out on the latest hot opportunity.”
D’Arcy Capital considers large cap value, financial firms, energy companies, emerging markets, and small caps (both domestic and international) of having the most favorable risk/return ratios. Within the consumer discretionary sector, investors should seek companies that produce premium products or offer experiential opportunities. Luxury goods and vacation destinations will continue to see gains at the expense of discount retailers and camping suppliers. Bond investors can still find opportunities in the municipal bond sector, by shortening durations, and purchasing inflation protected securities.