It has become commonplace to ask how stock markets can be rallying when the world is confronted by so much uncertainty. Financial factors such as interest rates and earnings still matter more to stock markets than politicians’ populist gestures, even when it reaches the level of nuclear sabre-rattling.
But there is a deeper, and even harder, question to answer: how is the stock market performing so well when almost everything about it apart from its overall level suggests that investors are indeed as worried as financial laymen think they should be?
To illustrate, we need to examine the value style of investing. In its purest form, this means the painstaking search for a few companies so undervalued by a capricious market that investors will scarcely lose, even if they go bust. That is still a good but very demanding way to make money.
But these days, when investors talk about value they tend to mean a way of analysing a market, or almost giving it an X-ray, by looking at how individual factors are performing, once it is assumed that all other factors are held equal. It is not difficult to isolate exactly how much a low price/earnings multiple, or a high projected stream of future earnings, has on stocks’ performance.
Generally, factors perform well when they are thought to be in short supply. When times are bad, investors gobble up stocks that can show growth, because this is in short supply. When the economy has momentum, they choose “value” stocks as their way to participate most cheaply in the upswing. So value underperformance generally implies that investors are feeling negative. And value, all across the world, is enduring a terrible year.
In Germany and Japan, MSCI’s value indices have underperformed growth indices by 6.6 and 7.7 per cent respectively, while US value has taken a particular pounding, underperforming by more than 11 per cent. A strong rally in the immediate aftermath of the US election, when hopes were high for a few weeks that the administration would usher a growth agenda, has now been cancelled out.
Using quantitative tools, we can see a little more of what is happening. Andrew Lapthorne of Société Générale compared the five factors that are of greatest interest to investors – profitability, quality (which generally means a strong balance sheet and consistent earnings – a conservative approach), and momentum, which entails buying whatever has been doing well recently, as well as growth and value.
In the past year, growth was plainly triumphant, but there is also great concern to buy profitable companies with strong balance sheets. These are the preferences of conservative and worried investors, which we would normally expect to see at a time of high recession risk.
Comparing the valuation of different stocks suggests that value is radically out of favour. Value stocks will always by definition be cheaper than others, but at a global level they are trading at a deeper discount to other stocks, in terms of price/earnings multiples, than at any time in a decade. There appear to be compelling bargains out there, but people are still not picking them up.
The term “value” is itself an oversimplified term. Looking at different multiples that can show that a stock is cheap, Mr Lapthorne shows that over history it is free cash flow yield – where investors look for companies throwing off a lot of cash in relation to their value – that has fared best. Buying low free cash flow yield stocks is ultra-conservative, as it distrusts both GAAP-related earnings, and leverage (as debt service costs will eat into free cash flow).
But over time it has worked very well – until the past three years, when the lowest free cash flow yield stocks have lagged behind the main universe by 15 percentage points. The only time it fared worse was during the dotcom bubble, when many literally believed that it was impossible to pay too much for a stock. There is no such mania this time, but there is a similar disregard for value.
Trends differ by country. When Style Research, a London-based research group, broke down performance by factors and by geography, they found a sharp change for the US this year. Value did well last year, with all the factors linked to value performing well; and has done terribly this year, with growth factors taking over. Investors are particularly bidding up prices of stocks with strong predicted growth.
China is different. The same analysis by Style Research shows value factors outperforming last year and this, with little variation. The country is in a clear-cut shift towards value, suggesting that investors have confidence that there is growth to be found there. The US market has done a better job of making investors rich over the past two years as a whole, but the internal pattern suggests that they badly lack confidence compared to China.
One final quantitative finding shows the level of worry about the US. Mr Lapthorne found that companies with strong balance sheets did very well, while those with weak balance sheets have been punished. Investors may not be discerning in other ways, but they are definitely worried about leverage.
How do we reconcile a calmly rallying market with so much turmoil? The most likely explanation, I believe, is monetary policy. With bonds still so expensive, investors are still buying stocks, relatively indiscriminately, but not enthusiastically. And they are very worried about what happens to the most indebted companies when interest rates rise. It is an unpalatable picture, but it seems to be an accurate one. firstname.lastname@example.org