Camping Out in Value Stocks? Rotation Could Be Afoot

Value stocks are thought to trade below what they are really worth and will thus theoretically provide a superior return.

The recent upswing in value stocks comes as the economy has seemingly crawled its way out of recession— for now. The question now is whether this bull run turns out to be ephemeral or it legitimately has legs.

Value stocks are affectionately known as such because they’re the market’s cheapest and most economically sensitive stocks. These babies have been dominating Q4. Since September 2, the Vanguard S&P 500 ETF [$VOOV] is up 6.8%. The S&P 500 is up 3.6% over that time, and the Vanguard S&P 500 ETF [$VOOG] has climbed about 0.9%. 

What a crazy bounce back from 2019, when value stocks were vastly lagging growth stocks. Yet value’s outpacing isn’t due to fundamental change in the way the market is working. Rather, it’s because investors expect economic growth to make a comeback.

Which adds up, given that millions of vaccine doses are on track for distribution within the next year and a new fiscal stimulus package is on the precipice. Many tranches of the economy have etched-out that heavily anticipated V-shaped recovery, and forecasts are leaning on sustained strength.

Stocks can become undervalued for many reasons. In some cases, public perception will push the price down, such as if a major figure in the company is caught in a personal scandal or the company is caught doing something unethical. But if the company’s financials are still relatively solid, then value-seekers may see this as an ideal entry point, because they figure that the public will soon forget about whatever happened and the price will rise to where it should be.

Not only would such an upturn help out cyclical stocks in the oil, financial, manufacturing and consumer-discretionary sectors, but inflation may be reflected in the pricing of their goods as well.

Furthermore, Treasury yields and other benchmark interest rates tend to rise during periods of economic expansion to reflect higher inflation. Those higher rates lower the value of future corporate profits. That’s because analysts use a “discounted cash flow analysis” to assess the intrinsic value of a company by forecasting their cash flow then “discounting” it back to the present day against a risk free rate. When rates rise, those cash flows are worth less, and since growth stocks are reliant more on future cash flows, it makes growth companies more sensitive to rate changes.

Regrettably, the recent rotation into value stocks may merely be a function of an expectation that economic activity will jump with the end of the recession and then stabilize, causing value’s surge to fizzle out. Some Wall Street strategists believe growth stocks’ earnings momentum will deliver yuge gains, and assert that valuations have become more reasonable in the past several months. That doesn’t mean value can’t run hot alongside growth, but longer-term outperformance may be unlikely.

That’s the view of Barry Bannister, Stifel Nicolaus’s head of institutional equity strategy, who expects the current trend to last a few years. He foresees that the trend is the result of a short-term bounce out of a recession, not a secular, or long-term, rotation into value.

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