Value, Growth And The Fed

Includes: SPY
by: Evariste Lefeuvre

With every Fed tightening cycle comes the traditional questions:

i. Should high dividend stocks underperform as they are close, in nature, to Treasuries? If high yield stocks are a substitute for bonds, then an increase in Treasury bond yields would require a lower stock price for relative yields to equalize (or at least come back to their long run relationship).

ii. Or, should growth stocks be dumped given that their future income stream will be discounted by higher yields? Given that those stocks' valuations and returns are much less certain (future dividends growth, viability of the business model), the uncertainty pertaining to the Fed's tightening should add volatility and reduce their price.

A glimpse at the chart below shows that second explanation is the most valid: value stocks seem to be outperforming growth stocks when interest rates are rising and conversely. Even though higher interest rates may signal stronger growth ahead, value stocks are still preferred in a rising yield environment.

There are two exceptions to that:

i. In the late 1990s and in spite of Alan Greenspan's warning of irrational exuberance, the expectation of a never-ending new economy drove the outperformance of growth stocks much higher during the bubble years of 1996-98 - a trend that continued in spite of higher Treasury yields throughout 1999. As real interest rates grew higher as a reflection of stronger growth, growth stocks outperformed. Yet later on, the relationship faltered.

ii. Since mid-2011, growth stocks have not outperformed value sub-indexes as much as what the reading of long-term yields would have suggested. Interestingly enough, over the last few weeks, US Treasury yields have ramped up to the level implied by the ratio of value to growth stocks.

The following chart shows that, on a relative return basis (3 months), the relationship has been inverted since early 2012. If history is a guide, given the strong performance of US Treasuries (data for UST are inverted), investors should have favored growth stocks, yet we see that value stocks outperformed.

This can be explained by investors' "search for yield" willing to reap the extra return provided by the high spread between dividend and Treasury yields. From a theoretical point of view it would mean that bonds and value stocks are "substitutes" (lower yield → lower D/P ratio → higher price for value stocks).

Will it last? Will value stocks underperform in a rising yield environment? (Higher yield → higher D/P ratio → lower price for value stocks)?

I doubt it, if I look at the most recent price behavior of Treasuries against value and growth stocks (second chart above).

From a fundamental point of view, I would consider that the forthcoming trend of US 10-year interest rates (upside) would clearly call for an outperformance of value stocks.

Tactically, the message would be more or less the same. Even though the theoretical link is not straightforward, reversals in the US economic news flow are generally a good leading indicator of the value-to-growth return differential as can be seen in the left chart below (one explanation may be the short-term link between US long-term yields and the news flow when QE does not affect the relationship).

In addition, the outperformance of small to big observed recently would call for higher value stocks against growth.

Click to enlarge

Bottom line: among both theoretical links between relative value/stock performance and US long term interest rates, the competition for yield between Treasuries and value stocks seems to be the least valid, empirically. Higher rates are not favorable to growth stocks on a relative value basis.

The recent disconnect between Treasury returns and the value/growth return spread can be explained by the search for yield that characterized the 2012/13 period.

As of now, strategically and tactically, my cross asset signs would suggest an outperformance of value over growth stocks or sub-indexes.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.