Investors have seen this story before...
With Growth a crowded and expensive trade, might Value offer better value?
Published September 19 2023
[Editor’s Note: A vacay with my BFF sister was too good to pass up. My normal weekly will return next week.]
… and they didn’t like the ending. Despite valuation challenges from a higher-for-longer Fed, Magnificent 7 mega-caps accounted for roughly three-quarters of the S&P 500’s first-half return and more than a quarter of its market cap. A lot of FOMO during Q2’s chase for all things AI. A few bumps since have seen Energy take over leadership, but that has as much to do with the run-up in oil prices than with any fundamental weakness in the Big Tech trade. Still a very narrow market. The last time large-cap Growth stocks dominated like this was the late ’90s. And we saw how that ended. Dot-com darlings got clobbered, the Four Horsemen (Microsoft, Intel, Cisco and Dell, representing 18% of market cap) plunged, the S&P went on a 3-year losing streak that ate up half its value and the Nasdaq shed 70% and wallowed for a decade, taking 14 years regain its losses.
Not saying we’re heading for a ’90s redux. Magnificent 7 profits and cash flows are high, and the market itself is nowhere near as speculative. The Nasdaq is trading 15% below late ’21’s record high and the S&P is off 7% from its early ’22 high. But even though large-cap Growth P/Es corrected slightly relative to large-cap Value this summer, tactical problems are emerging. The gap in earnings sentiment between Growth and Value as reflected in upward EPS revisions has started to narrow, Value factors have led relative to Growth this quarter and Growth is a crowded trade. Indeed, except for the depths of Covid when the FAANGs deflated and the Value trade perked up on reopening expectations, the differential between Growth and Value forward P/E multiples hasn’t been this wide since the late ’90s. Cyclicals remain unloved despite surprising capex, resilient consumers and rising productivity.
With rates elevated and defensive sectors as cheap as they’ve been in 30 years (Utilities’ net new highs—highs minus lows as a % of total issues—are at -93%, below a 1% percentile reading), something’s got to give, especially in an economy that looks to slow but skirt recession. The rise in oil prices—Brent crude is at a 10-month high—appears to have legs and worries about worsening bank struggles that grew out of last spring’s high-profile failures appear overblown. This has Energy and Financial companies raising earnings estimates, the former on improving fundamentals and the latter off downward revisions that were overdone. Even with its summer rebound, Energy’s forward P/E relative to the S&P is at a 30-year low. Only once since 1985 have regional banks relative P/Es been this low. And Financials, Consumer Services, Real Estate, Health Care and Consumer Staples are all well below their 30-year median relative P/E, Goldman Sachs says.
When a crowded trade breaks, it usually breaks hard. Witness the Nifty 50 in the ’70s, Real Estate and Energy in the ’80s, and the Four Horsemen in the ’90s. A Fed that may not be done—the market’s expecting a December move, though we’ll find out more this afternoon—could challenge Growth further. The nice thing about the current set-up is that sectors representing both “risk on,’’ i.e., cyclicals such as Energy, Financials and Materials, and “risk off,” i.e., defensives such as Health Care, Consumer Staples and Utilities, are historically cheap and populated with dividend-paying names. So, they arguably offer investors the potential to benefit and the opportunity to receive income regardless of which way the economy and the Fed breaks. Over the last 100 years, dividends have represented 59.4% of the S&P’s total returns, Strategas Research says, and 77.4% of total returns in the stubborn inflationary ’70s. Past performance is no guarantee of future results, of course, but that would be an ending that investors should like.