Market Factors and Macroeconomics — Part I

In this piece, I aim to address the recent market trends, the macroeconomic environment, and market dynamics. The articles are organized as follows the first discusses the factor rotation from growth to value. The next part looks at why growth has performed so well over the last decade and what has changed. The third part describes some of the major macroeconomic trends. Finally, the last section contrasts the flow vs. fundamentals dichotomy in the market.

Value Factor and Value Stocks

Over the past year we have seen a factor rotation with value stocks outperforming growth stocks. This outperformance is relative to the S&P 500 Index. So the outperformance is interpreted to mean that value stocks have had higher return relative to the market while growth stocks have had a lower return than the Index or have underperformed. This change is illustrated in the chart below. Over the last 6 months Value (blue) has outperformed the market while Growth (red) has underperformed.

Figure 1 Value vs. Growth performance relative to S&P 500 Index past 6-months

Value Factor

The value factor is traditionally described in terms of the book-to-price ratio of a stock. In academic terms the Fama-French HML (High minus Low) factor is the value factor. The HML factor is constructed by building a long-short portfolio by being the long the stocks with the highest book-to-price ratios and being short the stocks with the lowest book-to-price ratios. The main idea behind the factor is that stocks with high book-to-price are relatively undervalued and will go up in price, while stocks with low book-to-price are overvalued and will fall in price. Such an implementation of a value investing strategy can be classified as Quantitative Value. This is a suitable strategy if one has low conviction and is willing to hold many stocks.

Value Stocks

Picking individual value stocks with a high conviction is a different and very involved craft. In this case the investor is willing to hold a concentrated portfolio based on deep research on individual names. This research is based on valuation, business analysis looking for moats (barriers to entry), margin of safety in addition to a low price (trading at a deep enough discount to their intrinsic value). A common example of value stocks are the so-called Net-Net stocks as described by Benjamin Graham. These stocks have positive Net-Net value, where Net-Net value is given by:

Net-Net Value = Net Working Capital — Long-term Liabilities

Obviously being a Net-Net stock is not enough. The business should have strong operating metrics.

Value’s Problem

Why has the value factor performed so poorly over the past 4–5 years. The following chart looks at the relative overperformance of the value factor of the past 5 years as measured here value underperformed the market by almost 20%. We can also see the value to growth rotation started some time during late 2016 and early 2017. In fact, 2017 was the year that saw great bull market in growth stocks especially technology stocks.

Figure 2. Value vs. Growth performance relative to S&P 500 Index past 5-years

Since any value factor based portfolio did not hold any technology stocks or was actively short technology stocks it performed poorly. This underperformance is considered something of an anomaly because value investing has a strong track record. This is evident from the chart below It plots the cumulative performance of the technology stocks (purple), S&P 500 Index (blue), and value stocks (red) over a 12-year period from 2003 to 2015. It is clear from the chart that the value factor has consistently overperformed for an extended period. After the Great Financial Crisis (2008–09) the performance of value stocks and technology stocks has been close, but value has mostly underperformed until the divergence in 2016–17, when growth and technology stocks outperformed value and the S&P 500 Index by a wide (an understatement) margin. Overall, it can be said that the value factor has underperformed for at least a decade.

Figure 3. Technology, Value, and the S&P 500 Index from 2003 to 2015.

Causes & Conclusion

At this point it helps to look at some of the causes for this underperformance and see how we can modify the craft of value investing to match the changing market environment. Few oft cited reasons are:

1. Poor Measurement: It is often suggested that traditional valuation metrics and accounting measures like the P/B ratio no longer capture value stocks, and need to be modified to take in to account changes in the business environment.

2. Ignoring Intangibles: Over the past decade the importance of intangible assets like patents, brands, customer relationships etc. has come to the fore. Investment in intangibles has proven to be the one of the main factors is common to recent winners in the market.

3. Sector Overlap: The value factor has become synonymous with ‘traditional’ sectors like Financials, Industrials, Energy etc. Further value portfolios have been underweight or even explicitly short Technology, which has been the main reason for the poor performance.

4. US Focus: Most analysis of the value factor is based out of US markets. Other developed markets Europe, but specially UK and Japan are just as deep and diverse as the US markets. They may offer great bargains that sit well with the Value approach.

Where do we go from here?

The recent reversal in value’s performance has raised hopes for a longer turnaround in the market. Recent macroeconomic trends with increasing inflation and growth expectations further support the case of value. Finally, there is a need to understand the changes in the market and adapt our metrics to reflect the impact of those changes in our analysis. Such changes will allow us to expand the ambit of value even allow for some technology and software (remember Buffet owns Apple Inc.) companies to be included based on modified quantitative and qualitative factors.