- As the U.S. economy continues to improve, I believe key leading indicators, relative risk/reward and historical trends point to the potential for value stock outperformance.
By Rick Golod
Despite the economy's glacial pace in the first quarter of 2014, I believe economic growth can reaccelerate in the second quarter and is likely to continue improving. In this environment, value stocks - those that appear undervalued on price-earnings ratio, price-to-book, free cash flow or other metrics - look attractive to me primarily for these reasons:
- Buy signals from key indicators. The Philly Fed Index, a gauge of regional manufacturing activity, surged 15.3 points in March and 7.6 points in April.1 Since 2005, when this index improved, the S&P 500 Pure Value Index tended to outperform the S&P 500 Pure Growth Index.2 The Conference Board's Leading Economic Index (LEI), up 12 of the past 14 months, is also telling.3 In the past, when LEI accelerated, pure value generated nearly 700 basis points in excess return above the S&P 500 Index over a 12-month period.2
- More favorable risk/reward. Liquidity - such as the unprecedented stimulus provided by the Federal Reserve (Fed) - tends to reward risk taking and momentum investing. As the Fed is currently engaged in dialing down its stimulus, riskier (e.g., high growth stocks) and momentum-based strategies have underperformed, while value-style investing led year-to-date as of April 30.4 I believe value strategies will continue to garner investor favor as fundamentals, rather than liquidity, begin to matter again.
- Better positioned for rising interest rates and stronger dollar environments. Over the past 10 years, value beat growth 91% of the time when interest rates were rising and 82% of the time when the dollar strengthened.5 Of course, past performance is no guarantee of future results.
A more in-depth look at current opportunities in the U.S. and global equity markets is available in my full commentary, "Can the U.S. Continue to Lead Global Equities?"
1 Source: Bloomberg LP, April 30, 2014
2 Source: Cornerstone Macro LP, April 8, 2014
3 Source: Bloomberg, March 31, 2014
4 Source: Bloomberg, April 30, 2014, and Bank of America Merrill Lynch, March 31, 2014 and April 1, 2014
5 Source: Thomson Reuters Datastream, Dec. 2, 2013
Basis point is a unit that is equal to one one-hundredth of 1%, and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indexes and the yield of a fixed-income security. 100 basis points equal 1%.
Beta is a measure of risk representing how a security is expected to respond to general market movements.
The Conference Board Leading Economic Index is an economic indicator used to forecast changes in the business cycle based on a composite of 10 underlying components (including data on employment, manufacturing, consumer expectations, stock prices, money supply, interest rates, among others).
The Federal Reserve Bank of Philadelphia Business Outlook Survey (also called the Philly Fed Index) is a regional survey of the health of the manufacturing sectors in eastern Pennsylvania, southern New Jersey and Delaware.
PMI (formerly Purchasing Managers Index) is a commonly cited indicator of the manufacturing sector's economic health calculated by the Institute of Supply Management.
Price-earnings (P/E) ratio, also called multiple, is a common valuation metric for stocks that compares a stock's share price to its per-share earnings.
Price-to-book value is a common valuation metric for stocks which compares a stock's share price to its book value per share.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
The S&P 500 Pure Growth Index is a style-score-weighted index that measures the performance of S&P 500 stocks with pure growth characteristics and excludes those with both growth and value characteristics.
The S&P 500 Pure Value Index a style-score-weighted index that measures the performance of S&P 500 stocks with pure value characteristics and excludes those with both growth and value characteristics.
A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
Growth stocks may be more susceptible to earnings disappointments, and value stocks may fail to rebound.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
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