This time last year, international financial markets were in the midst of the coronavirus shock. Central banks were embarking on aggressive interest rate cuts and other stimulus measures to steady the financial system, as equity markets were plummeting and bond yields dropped to historically low levels.
The S&P 500 plunged by 35.4 per cent from the all-time high on February 19, 2020, to its low on March 23, 2020. Last year will always be remembered as the year associated with COVID-19 and the severe impact that the virus had both from an economic perspective as well as on everyday life across the world.
The outbreak of the pandemic led to the greatest contraction in global economic activity in decades. However, one of the most remarkable developments last year was the extent of the sharp rally in the US equity market from the low reached on March 23, 2020. The S&P 500 ended the year with a gain of 16.3 per cent while the Nasdaq Composite index surged by 43.6 per cent.
As was often highlighted by numerous financial journalists over recent months, the performance was spearheaded by growth stocks such as the large companies (Facebook, Amazon, Apple, Netflix and Google collectively known as the FAANG’s) as evidenced by the superior performance of the Nasdaq, as well as those companies benefitting from the trends arising from the pandemic such as those that enabled working from home namely Zoom, Peloton and several others.
On the other hand, the so-called ‘value stocks’ in cyclical sectors, such as energy, financials and industrials, underperformed for a large part of 2020. Value investing can take many forms but, in essence, this philosophy is based on identifying cheap companies that are trading below their true worth, an approach long favoured by Warren Buffett.
Another very successful value investor was Sir John Templeton, who had described his approach as follows: “Buy stocks for less than they are worth and hold them as long as it takes for the market to appreciate how undervalued they are.”
One key reason why growth stocks performed strongly over the past 12 months, despite the economic impact of coronavirus, is due to the very low level of bond yields. When performing company valuations, the lower level of bond yields boosts the current value of expected future earnings of companies as the future income stream is discounted at a lower rate.
However, the rollout of COVID-19 vaccines and upbeat expectations of a gradual resumption to normality during the course of 2021, which were also aided by the approval of the US$1.9 trillion stimulus bill in the US following the election of Joe Biden as president, led to a revival of value stocks in cyclical sectors that had underperformed growth stocks in 2020.
The rotation away from technology companies into economically-sensitive sectors, such as financials and energy, led to a significant outperformance of value stocks compared to growth stocks in the past six months.
From end October 2020, the Dow Jones Industrial Average rallied by 23 per cent outperforming both the S&P 500 (+20 per cent) and the Nasdaq 100 (+18 per cent), which have much higher weightings towards technology companies. Since mid-February 2021, the Nasdaq 100 index dropped by six per cent, while other indices with a greater focus towards financial stocks and energy companies performed significantly better. In fact, over the course of the past five weeks, the Dow Jones Industrial Average added more than three per cent, largely driven by the gains in the larger-weighted components in the index such as Goldman Sachs, Boeing and UnitedHealth.
The rotation away from technology companies into economically-sensitive sectors, such as financials and energy, led to a significant outperformance of value stocks compared to growth stocks in the past six months
Following the upturn in bond yields to their highest levels in 12 months − which is the main factor that led to a decline in growth stocks in recent weeks (higher bond yields reduce the relative appeal of owning growth stocks based on their future earnings power) − there is a widespread debate on which investment approach (growth or value) will lead to the best returns during the rest of 2021.
Proponents of value investing believe that the combination of high valuations of growth stocks coupled with a robust recovery from the pandemic will continue to result in a switch between the two investing approaches. These same value investors argue that certain valuation metrics for value stocks, based on factors such as asset value, earnings and cash flow, are still low compared with average levels stretching back several years.
Another renowned value investor predicted that the US is heading for a repeat of the ‘Roaring Twenties’ seen a century ago, that will encourage investors to move away from technology stocks and increase allocations to those companies more sensitive to the economy, on the back of higher economic growth as well as rising interest rates and inflation, which will eventually lead to a pullback in liquidity support from central banks.
Other financial commentators argue that the recent bond market weakness can be seen as confirmation that the economic recovery is materialising and as such, equity investors can benefit from a stronger economy that boosts the earnings leverage of companies.
In fact, although the recent sharp rise in bond yields has negatively impacted growth stocks, historical data suggests that rising rates have coincided with periods of positive performance for equities in most cases.
Statistics compiled by one of the largest banks in the US indicate that over a long number of years when the benchmark 10-year bond yield started a rising cycle (there were 19 rising rate cycles since 1920), in 74 per cent of the cases, the S&P 500 traded higher with an average return of 13.3 per cent per annum. In more recent years, during the last five phases of rising interest rates since 1998, the S&P 500 generated an average annual return of 30.2 per cent.
Many investors believe that as long as the rise in yields is driven by an improving growth outlook, it should support corporate profits and create a beneficial backdrop for the stock market. The news earlier this week that the US president is seeking to present a proposal for an infrastructure plan totalling US$3 trillion could also lead to a continued positive momentum for the equity market,although this may coincide with an increase in taxes to fund such an ambitious programme.
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