Can Expensive Stocks Be Cheap Relative to Value Stocks?

 |  Includes: IUSG, IUSV, IVE, IVW, VTV, VUG
by: Jersey Trader

In a recent article on Bloomberg, a market strategist at UBS uses the valuation spread of the industries with the highest and lowest P/Es to measure relative value between high P/E (growth) stocks and value stocks. While I disagree with his conclusion that high P/E stocks will outperform value stocks, I think the data shows that the valuation spread has an effect on future relative performance.

A short study by the Brandes Institute has a chart in it with the gap in valuations of growth and value stocks. This was measured by sorting stocks by P/B, then using the ratio of the median P/B in the top decile to the median P/B in the bottom decile. The correlation of this ratio to the future 5 yr returns of value stocks relative to growth stocks appears to be fairly strong.

In Jeremy Grantham's 1q 2010 letter, he discusses growth versus value and has a chart of the relative valuation of the cheapest 25% of stocks by P/B to the market. Again, this method of measuring the valuation spread appears to have a fairly strong correlation to future relative performance of value stocks vs. growth stocks.

While I don't have the historical data and can't find out exactly how high the correlation is between the valuation spread and future relative returns, it certainly seems high enough that a reasonably close guess can be derived from it.

So what relative performance can we expect from growth stocks vs. value stocks over the next several years? Currently, the ratio used to measure the valuation gap in the study by the Brandes Institute is around 11.5, which is slightly above the median of 11.1. The metric in Grantham's 1q 2010 letter is around 0.48, a little bit below the median. For both metrics to meet their median level, value stocks would have to outperform growth stocks by a small amount.

And back to UBS's forecast of growth stocks outperforming value stocks, I think there are a few possible reasons I came to a different conclusion.

  • I used P/B, not projected P/Es. The earnings in the denominator are more volatile than book value and the P/E can often be at levels that do not make sense. Also, projected earnings are often very different from actual earnings.
  • I used the spread between stocks instead of the spread between industries.

So in conclusion, when the spread between valuations of growth stocks and value stocks has reached an extremely low point, than growth stocks have outperformed value stocks. Thus, even though it may sound counter-intuitive, growth stocks can become cheap relative to value stocks. Although this is possible, it is unlikely that this is currently the case.

Disclosure: No positions