J.P. Morgan strategists Davide Silvestrini and Marko Kolanovic told clients on November 10 that they believed markets were “on the cusp” of a rotation into value similar to the one experienced in 2016 and 2017. But therein lies the paradox.
When President Trump was elected in 2016, there was indeed a short-lived boomlet in value stocks. Given the narrative of his campaign, which promised to re-energize mature industries in smokestack America, the market adjustment made sense.
But reinvigorating industries like coal and steel proved more difficult in reality than in theory. By 2018, growth stocks returned to the limelight. The current notion that value is poised to make a run would seem to have more support from valuation disparities than from anything in President-elect Biden’s agenda, assuming he is certified.
Serious students of financial markets prefer to look beyond politics to understand why asset classes behave differently. One lens to address the disparity arises when one decomposes the sources of equity returns, notes Chris Brightman, chief investment officer of Research Affiliates.
Essentially, stocks possess three components: the return from dividend yields, the growth in earnings per share (EPS) and the change in price-to-earnings multiples. Needless to say, growth strategies have lower, if any, dividends, and higher rates of EPS expansion.
But Brightman cites another phenomenon—rebalancing, or what is called migration—as a driver of the performance gap. Simply put, many growth companies become value stocks while fewer make the opposite journey.
On rare occasions, companies like Microsoft take a round trip: It’s gone from being a growth stock in the 1990s to a value holding from 2000 to about 2013 and then back to growth in recent years. It is far more common for companies to take a one-way trip from growth to value, as Cisco Systems did in the years following 2000.
The Standard & Poor’s growth and value indexes usually rebalance about the same number of stocks each year, Brightman says. But since growth stocks are subject to more dramatic price swings, rebalancing can be more expensive. “You tend to be buying high and selling low,” he says. “Value is the exact opposite” when it comes to the price differential associated with the migration effect.
Multiple Expansion
Multiple expansion in the growth universe, however, has been far and away the primary source of the performance disparity gap. Current valuations for high-octane equities can be viewed as completely rational when one factors in the effect of interest rates into dividend discount models.
Brightman cites the Gordon dividend discount model, the simplest, most intuitive of such models, he says. It simply takes dividends (D) and divides them by the cost of capital (K), or discount rate, minus a company’s growth rate (G), or D/K-G.