Three Trends that are Dominating the Market: Will They Revert?

10.22.2020 - Douglas Cohen

What is working in the financial markets today will likely work tomorrow. That’s essentially the very definition of momentum. Over longer periods of time though, most elements of the financial markets have tended to revert to the mean. That shorter-term versus longer-term tension is at the very heart of some of the most heated current investment portfolio debates.

The post-2008 Great Financial Crisis (GFC) era of extremely low interest rates, marked by a near-constant “don’t fight the Fed” mantra that has become even more pronounced in the COVID-era, has caused many to question whether mean reversion will ever arrive.

That’s particularly true in the case of the three most dominant positioning trends of the last dozen years:

  • US markets over foreign markets
  • Growth over value
  • Large-caps over small-caps

Although there is always a case for a short-term countertrend move where, as Tom Petty might have said, “even the losers get lucky sometimes,” below is a high level summary of the contrarian-oriented arguments for a more durable sea change in each of those three prominent trends.

Trend #1: Outperformance of US versus International Equities

For all the persistent drama in Washington, D.C., most global investors have strongly embraced America’s world-class returns on equity, rule of law, entrepreneurial culture, labor flexibility and technology prowess. The aggressive steps taken during the GFC ultimately enabled US banks to emerge in better shape than most of their global counterparts, and the US continued to benefit from its status as the world’s dominant reserve currency.

As such, the S&P 500 Index has generated a total return of 10.58% per year versus just 3.48% for the rest of the world since the Great Financial Crisis.[1]

US Equities Have Significantly Outperformed International Equities Since the GFC

Source: FactSet 

The counter-consensus view favoring a tilt away from the US has three main elements:

  1. The first is simply that the valuation gap has become too extreme with the S&P 500 currently at about 22 times consensus 2021 earnings and a 1.7% dividend yield versus the MSCI All Country World Index ex US at approximately 17 times 2021 estimated earnings and a 2.7% yield.[2] Still, those gaps are only modestly wider than they have been for most of the last dozen years, consistent with US global leadership in generally high-multiple, low yielding technology stocks. It seems unlikely that valuation alone will be the catalyst for a sustained move into overseas-domiciled stocks. Rather, there will likely have to be some fundamental changes at the margin that favor the rest of the world.
  1. The second main argument in favor of overseas stocks is that the US is losing its global competitive edge due to rising political polarization and inequality, a surging debt burden, a demographic “time bomb” with the looming retirement of many baby boomers and a narrowing educational gap versus much of the developed and developing world.
  1. At the same time, the third contention is that other key economies are improving their competitive outlook as the US is slipping.

Those arguments include a belief that Europe (still the dominant non-US exposure at 42%[3] of the  MSCI All Country World (ex US) Index) is slowly but surely progressing in the right direction as it moves past the depths of the Greek/southern European crisis that threatened to lead to the dissolution of the European Union just a few years ago. The tensions between Germany and its southern neighbors seem to have dissipated markedly, at least for the time being. Furthermore, while the US maintains a sizable advantage in the depth and breadth of its technology sector leadership, several rapidly growing mid-sized European tech companies are narrowing the gap.

Europe is also increasingly challenging the US lead in healthcare, the third largest global sector and one with unusually strong demographic support. Elsewhere, the Japanese market, which reached a seven-month high a few weeks ago despite the recent near 10% correction in US markets, also has some formidable, if often underappreciated, tailwinds. Though still below its G7 peers, Japanese labor productivity growth has outpaced the other six countries since 2010. Despite Japan’s well-documented demographic challenges, the rising productivity has helped to enable Japan’s earnings growth to match that of the US over the past decade. Japanese stocks are as inexpensive as they have ever been relative to the US counterparts.[4]

The largest wildcard in the US versus overseas equity debate—particularly for emerging market equities—is likely to be the US dollar. After a decade of general strength topped by a surge in the early days of the COVID-crisis, the trade-weighted US dollar has declined by approximately 7% since May.[5] The spring/summer pullback reflected the extraordinary monetary and fiscal stimulus from Washington, D.C. as lower interest rates and a rapidly mounting debt have made the currency less attractive to hold. Most global investors had been heavily exposed to the US dollar and may well look to balance out their positions given the Fed’s unambiguous guidance that rates are likely to stay near 0% well into 2022.

Trend #2: Outperformance of Growth Versus Value Stocks

Based on recent market history, it is difficult to believe that value stocks dramatically outperformed their growth counterparts from 1927 through 2007. Times have definitely changed.

The chart highlights one of the largest growth-over-value performance disparities on record—right up there with the pre-2000 bursting of the tech bubble. In the post-GFC period of sustained low interest rates and low-to-moderate economic growth, investors have been willing to pay a premium for companies that could truly grow, be it the oft-cited FAANG-like stocks, momentum-oriented industries such as biotechnology or many private “unicorns.”   

Growth Stocks Have Significantly Outperformed Value Stocks Since the GFC

Source: FactSet

Now that the longest economic expansion in American history is, well, history, the traditional market playbook says that the dawn of new cycle should usher in a sustained rotation to more value-oriented cyclicals such as energy, materials and industrials.

Other contributing factors to a potential reversal include aggressive antitrust activity directed at high profile tech-oriented darlings and any increase in inflation expectations that could cause the consensus to start anticipating higher interest rates more quickly than currently envisioned. With financials—the largest value-oriented sector—now constituting a lower percentage of the S&P 500 than during the depths of the GFC (9.5% vs. 9.8%)[6], any bottoming of real interest rates and/or a realization that US banks appear reasonably well-capitalized to ride out the COVID-induced storm could ignite a long awaited sustained rotation back toward value.

To be clear, while the current macro-oriented range of possible outcomes is unusually high given the uncertain COVID path and the upcoming US elections, we are hard-pressed to see an imminent transition back to value. Many of the scenarios highlighted above seem unlikely to play out anytime soon given the strong likelihood of continued moderate “Goldilocks”-like economic growth once   COVID conditions normalize, along with sustained low interest rates given the Fed’s willingness to let inflation overshoot.

Two last points:

  • First, while many market participants and “style box” enthusiasts tend to dwell on the growth versus value debate, our long-standing bias has been toward what we see as a high-quality versus low-quality tradeoff. Our general preference for high quality has been marked by elements such as a wide and deep competitive moat, high and sustainable cash flow creation, a strong balance sheet and an exceptional management team.
  • Second, the traditional value and growth classifications based on book value have lost much of their relevance over the last nearly 40 years as the mix of corporate investment has shifted from about a 1.7x tangible assets to intangible assets ratio to about 1.4x intangible to tangible assets, according to analysis done by Morgan Stanley.[7] In this particular case, the traditional value versus growth analysis truly is “different this time.”   
Trend #3: Outperformance of Large-Cap Versus Small-Cap Stocks

Much like the growth/value discussion, the traditional market playbook favors large-caps in the late stages of a bull market, but transitions down the market cap curve upon the dawn of a new cycle.

Smaller companies are seen as more economically sensitive and more likely to benefit from the stimulus that follows an economic downturn. No wonder that the equal-weighted S&P 500 has outperformed the traditional market cap-weighted index coming out of every recession since the early 1970s.

Large-Cap Equities Outperformed Small-Cap Equities Since the GFC

Source: FactSet

This particular COVID-dominated recession has a unique dynamic, though, in that it continues to have a far more adverse impact on smaller, “Main Street” oriented businesses as opposed to larger, more financially secure behemoths.

Small-caps also tend to be more US-oriented than the overall S&P 500. This creates a dynamic that may lead to continued underperformance if the elements highlighted in the US versus overseas section above come to fruition.

Just to make sure that the seemingly random Tom Petty reference in the initial paragraph doesn’t stand in complete isolation, while I’m not convinced that large caps are about to  begin “Free Fallin’” when Apple becomes worth more than the entire consumer staples sector, it seems to be a clear anecdotal sign that the large-cap trade has probably gone too far. The waiting may indeed be the hardest part for small-caps, but we think that the least-loved part of the market by most of the aforementioned style box enthusiasts—small-cap value—is probably fertile territory for old-fashioned stock pickers.     

[1] Source: Bloomberg, as of 9/20/20.

[2] Source: Bloomberg, as of 9/20/20.

[3] As of 9/20/20.

[4] Factset, As of 9/20/20.

[5] As of 10/21/20.

[6] As of 9/20/20.

[7] As of 9/15/20.

The information provided is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy, or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.


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