This week has seen a truly shocking set of reversals in the stock market. On the surface it’s been pretty calm, with the S&P 500 moving less than 1% each day. But underneath the churn has been extraordinary, with the biggest rotations out of high-momentum stocks and into cheap value stocks since the 2008 bank bailouts.I’ve been waiting a long time for a value resurgence. Unfortunately, I don’t think this is it.
To see why, we have to tell a story both about why a strategy of buying cheap stocks has been doing so badly for so long, and about why it turned around this week. Sadly, the short-term story isn’t a reversal of the long-term story, and so isn’t likely to persist. The short-term story is pretty simple: threats to the economy receded, and investors were willing to take risks again. Trade talks with China are back on, a no-deal Brexit is less likely, hopes are rising for German fiscal stimulus, and John Bolton’s exit means the U.S. is less likely to start a war. The future looks less dark than it did, so investors sold the defensive positions they’d been buying for ages, and bought the stocks that will benefit if a better economic outlook lifts everything. Bond yields naturally leapt, with the 10-year U.S. Treasury yield rising by the most in five days since the surge in business optimism that followed Donald Trump’s 2016 election.
On the surface, this week has been pretty calm, but underneath has seen a shocking set of reversals for the stock market.
Bryan Smith/Zuma Press
Momentum investors who buy what’s going up hold lots of big safe companies and stocks that look like bonds, and these suffered. Value investors hold lots of banks and cyclical stocks sensitive to the economy, and these benefited. That this wasn’t just about value was shown by smaller company stocks: the Russell 2000 had its best two-day performance compared with the S&P 500 since November 2016. This week’s reverse was so powerful because hedge funds and other leveraged investors were almost unanimous in being defensive, and all rushed at once to cover short positions in value stocks and dump long positions in safer stocks. As Evercore ISI’s macro research analyst Dennis DeBusschere says: “People got overextended on their bearishness on the economy relative to reality. That’s reversing because they’re realizing that the economy, at least in the U.S., just isn’t as bad as feared.” Value did well, but it was a side effect of a broader market move. It wasn’t obviously the end of the trend of cheap stocks being beaten by growth stocks such as the FANGs,
Amazon, Netflix and Google (now Alphabet), that’s lasted for more than a decade—the longest period of value underperformance since the 1930s. True, there was a significant rotation from growth to value, but there were bigger shifts last year in both November and July that petered out.
There are two leading explanations for value’s poor performance for the past decade. The first is that unending cheap money fueled spending sprees by disruptive tech stocks, allowing them to run at a loss and so steal business from traditional companies that try to make profits. Leading examples are Tesla, Uber and WeWork, and higher bond yields offer some hope that this might reverse. I prefer a second, linked, explanation, that there’s a wave of technological change under way and the market has divided between the disrupters, who can afford to take advantage of it, and the disrupted, who can’t. New research by Baruch Lev of New York University’s Stern School of Business and Anup Srivastava of Calgary’s Haskayne School of Business found that since 2007 value companies had the weakest profitability since 1970, while what they call “glamour” stocks had their best profitability. With little internally generated cash, low valuations that make it hard to raise new capital, and banks tightening up lending after the crisis, value stocks couldn’t finance the research required to keep up with the disruption to their businesses. Losers kept losing, and winners—mostly—kept winning.
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My hope earlier in the summer was that the big gap in valuation between growth and value meant much of this disruption was now priced in, although Messrs. Lev and Srivastava conclude that this isn’t true for the median stock (I used standard capitalization-weighted gauges). I still cling to the hope that value stocks are too cheap and investors are paying too much for growth, but this week’s value rebound wasn’t because others came around to my view. It’s welcome good news for value investors for now, but it’s unlikely to last. Write to James Mackintosh at James.Mackintosh@wsj.com
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