Since the beginning of this week, strong economic data has raised concerns about the prospect of the Federal Reserve cutting interest rates three times this year. As the yield of US treasury bond bonds fluctuates upward, the recent trend of NASDAQ has struggled, and the rise of AI leaders has slowed down. At the same time, cyclical sectors such as energy and raw materials have shown signs of recovery, and factors such as monetary policy and valuation have gradually made the topic of the rotation between value stocks and growth stocks more active.
What are the advantages of value stocks
Since last year, the rapid development of artificial intelligence has made technology stocks the main players in the market. However, there are indications that this situation is undergoing subtle changes, including cyclical industries such as energy, finance, and industry catching up and becoming the new darling of investors.
Many Wall Street strategists suggest clients look at value stocks. Valuation, cash flow, and dividends have become reasons for optimism. Savita Subramanian, Global Chief Strategist at Bank of America, said that all these factors provide convincing reasons to consider value stocks. "From a historical perspective, the S&P 500 index has been expensive on almost all indicators. However, for investors, we see a very convincing stage for value stocks."
According to FactSet's statistics, the overall P/E ratio of all 11 industries in the S&P 500 index is 21 times, with cyclical sectors such as energy, real estate, and finance below 15 times, while the P/E ratio of the technology sector has reached an astonishing 38 times.
Valuation information for the 11 major sectors of the S&P 500 index
Glenmede's head of investment strategy and research, Jason Pride, calculated that as of the third week of March, the valuation of growth stocks in the market was at a historical 93 percentile, which means they are already quite expensive. Value stocks in the market are currently in the 77 percentile, which is relatively more reasonable.
In addition to lower valuations, higher free cash flow also helps them weather any short-term turbulence when the Federal Reserve hesitates whether to cut interest rates. In addition, value stocks also offer higher dividend yields, bringing decent returns to investors. The value investment theory of Warren Buffett, the founder of Berkshire Hathaway and the stock god, has been widely discussed by the outside world for decades.
Michael Hunstad, Deputy Chief Investment Officer and Global Equities Head of Northern Trust Asset Management, said that Tesla has fallen nearly 20% this year, indicating how quickly growth stocks are reversing. He revealed that the company has been increasing its position in industries such as healthcare and energy. Value stocks are better able to withstand longer term high interest rate environments than growth stocks because they have shorter cash flow maturities and are less sensitive to borrowing costs.
Potential challenges of growth stocks
Since bottoming out in October last year, the US stock market has been rising for five consecutive months. According to Dow Jones market data, the Nasdaq index, which is dominated by technology stocks, rose more than 27% during this period, marking the largest range increase since August 2020.
According to Goldman Sachs data, driven by the tech giants, the P/E ratio of the S&P 500 index is already 13% higher than fair value. Although this does not necessarily mean that the market is coming to an end, high valuations often lead to a decrease in returns in the coming months, and sluggish economic growth is the most likely catalyst. Goldman Sachs research has found that after exceeding the 10% overestimation threshold, the median six-month return on the index will drop to 2%.
Morgan Stanley strategist Marko Kolanovic recently warned in a report that there will generally be a pullback in history after investors invest in so-called momentum stocks such as the Big Seven. "Momentum is a dynamic stock factor that often becomes crowded and inevitably undergoes drastic adjustments (i.e. momentum collapse)." He said that most companies in the United States and globally are struggling to improve profits and maintain profit margins, as higher interest rates persist for longer periods and the halo effect of artificial intelligence stocks leads to a surge of funds into ultra large cap stocks. "Given this relationship, coupled with very optimistic investor sentiment and positions, this relationship may reverse when the artificial intelligence boom reaches its peak."
It is worth mentioning that in the Bank of America Global Fund Manager Survey released last month, although long technology is still the most crowded trade. However, on the issue of whether there is a foam in AI, differences between institutions have gradually emerged.
Ed Yardeni, a renowned Wall Street analyst and founder of research firm Yardeni Research, is attempting to find signals of market pressure through changes in long-term profit growth (LTEG) expectations. "Behind the rapidly rising stock prices, institutions will experience a positive feedback loop as they continuously increase their estimates of a company's revenue, earnings, and profit margins, and vice versa. However, the growth rate of enterprise profits in the entire market cannot continue to be more than twice the economic growth rate, so the long-term earnings prospects of technology companies may be overly optimistic," he said.
Yadini summarized examples of past turning points in long-term profit growth. In September 2000, the overall market LTEG once reached a peak of 18.7%, which was on the eve of the bursting of the Internet foam. In October 2018, the company's tax rate reduction increased its profit margin, with LTEG reaching 17.6%. At present, the LTEG of the US stock market is 18.4%, with 8 companies with a market value of over $1 trillion having LTEGs of around 38%, with Nvidia reaching the highest of 102.5%.
