The S&P 500 and equities in general have done very well, approaching record highs. Still, there’ve … [+]
The markets are a lot like what they say about the weather. If you don’t like what you’re seeing right now, just wait a little while. Investors like us who favor value stocks have been waiting for a change in the weather for some time, but it’s finally happening. So far this year, the S&P 500 and equities in general have done very well, approaching record highs. Still, there’ve been some recent changes foreshadowing a shift that looks to favor fundamental stock pickers going forward.
The catalyst for this shift is the change in the 10-year Treasury yield which moved up – from 1% at the start of 2021 to its current rate of 1.62%. That doesn’t sound like much and is in fact rather low by historical standards. But it’s enough to have caused all kinds of uncertainty in both the equity and fixed income markets. The main impact in the equity markets is on high-growth Nasdaq companies whereas the effect on slow growth, value stocks will be minimal.
The rise in the 10-year Treasury yield affects the Discounted Cash Flow valuation model which analysts use to determine a company’s valuation. Higher interest rates cause the value of cash flows that are years or even decades away to be worth much less over a short period of time. For a company with expected earnings that will occur at some very distant point in the future, a higher discount rate will clearly result in a big change in current valuation.
There’s no doubt that the pandemic has been a shot in the arm for many of those Nasdaq tech companies as well as others like home delivery services. But now that vaccinations are becoming widespread and states are opening up or at least easing their restrictions, people are likely to a little become less dependent on them which is likely to decrease their current revenue and earnings growth rates. These for the most part are still good companies but as demand for the services that boomed over the last 12 months declines, so will revenue and earnings.
These developments appear to have gotten investors to start thinking about the more traditional economy, non-technology stocks that haven’t benefitted from the work-from-home and social distancing mandates. It seems logical that these traditional firms with strong and steady current cash flows should benefit as customers return and business returns to normal.
The shift from value to growth stocks was long-anticipated well before the pandemic struck, but it certainly accelerated over the last three months. So now, we’re seeing a sudden and dramatic shift, due to the upturn in the discount rate which hurts technology and long-dated high growth companies more than stable businesses with current cash flow. Thusly, we expect a shift from new economy names back to old economy businesses and a return to fundamental analysis.
For value investors, the likelihood that value investments will outperform high-flying technology companies is quite refreshing. It’s been frustrating for value investors rooted in fundamentals to find good companies that the market ignores. Now, it looks like the market will start respecting good companies with solid cash flow in the here and now once again.
There are many companies in traditional sectors of the economy—oil, auto and chemicals, industrials, telecommunications infrastructure, to name a few—with solid steady cash flows that the market has ignored in favor of fast-growing tech names. As some of the highest-flying tech names (think Tesla) start to come closer to Earth, these steady engines that drive huge sectors of the economy are starting to get more attention.
As in any market realignment, there will be winners and losers but in the current environment it looks like people who conduct traditional analyses and do fundamental research on businesses should outperform those who blindly throw money at extremely high growth companies or meme stocks.
The fixed income market also bears some attention. As has been pointed out in this blog previously with $13 trillion in negative-yielding debt, there remains serious danger of a bubble, although the significant boost to 10-year yields recently may foretell additional change in this market.
The biggest risk in fixed income markets is always the risk of inflation. Certainly, the new $1.9 trillion stimulus plan which President Biden just signed ratchets up risks that investors will eventually fear much higher inflation. At the same time as the economy recovers from COVID, there’s a less apparent need for extreme monetary stimulus. Thus, keeping interest rates at such low levels, even though the Fed has committed to doing, may no longer make sense.
As we head into the second, third and fourth quarters of 2021, fixed income investing remains fraught with risk both from inflation and the possibility of a bubble bursting. On the equity front, we expect to see more attention paid to fundamentals and value stocks. At the same time, event-driven catalysts, such as spinoffs, special dividends, or mergers and acquisitions, can continue to offer outperformance. The remainder of the year should reward value investors who have an ability to analyze these things and find compelling trades.
