Warming Up to a ‘Value Rotation’

SUMMARY

• Growth stocks have outperformed Value for 15 years.
• However, macro conditions potentially starting to favor Value, in our view.
• Relative price momentum change needed for confirmation.
• We will ‘lean not leap’ into any ‘regime change.’

“Being too far ahead of your time is indistinguishable from being wrong” – Howard Marks, Oaktree Capital Management

One of investors’ hardest tasks is navigating a ‘regime change’ – a profound change in the macroeconomic factors that drive relative outperformance of certain types of stocks or other assets. Successful navigation involves both accurate interpretation of economic data, as well as how the Fed’s reactions to that data may impact earnings and valuation multiples. This layered nuance leaves ample room for error, in our view. Being ‘early’ in positioning for a potential regime change can be indistinguishable from being ‘wrong’. Thus, we take a cautious, humble approach to identifying and adjusting for potential regime changes in Riverfront portfolios. Instead of ‘leaping’, we try to ‘lean’ into a burgeoning theme as we start to see both fundamental and technical confirmation.

Good Reasons for 15-year Outperformance by Growth Stocks

One example is the decades-long debate concerning when ‘Value’ stocks might start to structurally outperform ‘Growth.’ US large-cap Value (as defined by the S&P 500 Value Index) has significantly underperformed its Growth equivalent for 15 years, as shown by the chart below. We attribute this to two main factors. The first was subdued economic growth since 2008’s Great Financial Crisis, which caused cyclical business models to struggle, and placed a greater premium on high growth business models, especially technology.

More recently, sharply rising interest rates since 2021 placed pressure on Value and cyclical balance sheets, which tend to have higher levels of debt and shorter maturities.

Regime Shift Alert: Macro Backdrop May Start to Favor Value Stocks

It appears to us the macro environment may be in the early stages of a potential regime shift towards Value. Moderating inflation data and the Fed’s increasingly dovish posturing both seem to be suggesting a shift away from a “higher for longer” mindset around interest rates. The key is whether the Fed has pulled off a ‘soft landing’ and avoided recession, or whether a downturn is just around the corner. Interest rate shifts impact the economy with a lag, and we do not yet know the full economic impact of the 5%+ Fed funds rate that has been in place for over a year now. We place a higher probability on a soft landing, because we believe the US economy is exhibiting low financial stress and economic indicators are resilient. We think the most likely outcome is a mildly ‘reflationary’ environment – one where inflation remains contained but does not quickly fall to the Fed’s 2% target.

Although the combination of lower rates and moderate inflation would likely be a tailwind for all equities, we think it is one where Value stocks that have faced a headwind in the higher interest rate environment will thrive. Lower rates and moderately elevated inflation create steady nominal economic growth, which fuels sustainable revenue growth and enables refinancing for credit-sensitive companies, in our view. Thus, it is possible to foresee a potential rotation into ‘Value’-oriented sectors and themes, such as energy, industrials, small-caps, and/or Japanese equities. It is worth noting that we do not expect prices of the ‘Magnificent 7’ tech companies to necessarily drop in this environment, but instead to cede leadership to relatively cheaper Value stocks over time.

Our assessment of Q2 earnings, discussed last week, is also consistent with a scenario of a Value rotation. While growth-heavy US large-cap continues to be the strongest segment for earnings, an improvement in more Value-oriented market segments is evident. As the Fed unveils its interest rate plans, we will continue to monitor the situation and adjust portfolio exposures accordingly.

Portfolio Conclusions: Still Favoring US Large Cap stocks; Starting to Lean into Value-oriented Themes

As Howard Marks stated so eloquently, to be early is indistininguisable from being wrong. Although we currently maintain our bias to Growth stocks, we have contemplated a Value rotation since at least 2020, recognizing that the market does not cleanly rotate from one state to another, and the migration has many unpredictable twists and turns. It is always tempting to try and “call the bottom” in asset classes, whether absolute or relative. Our preference is to continue to monitor the macro and earnings environment, and to slowly ‘lean’ into Value-oriented themes within our portfolios as we gain confirmation of a trend change. Looking at the relative strength picture in Chart 1 above, it is clear that such a conclusive long-term trend change has not yet taken place… but a nearer-term bottom may be forming.

Two of our key risk processes - proactive risk management and position sizing - should help temper any excessive enthusiasm around a Value rotation, nascent as it may be. We must remain disciplined, as any negative data points could start to point to an economic slowdown and quickly change the market narrative…as we experienced in early August. Our team’s motto of ‘Process Over Prediction’ suggests healthy skepticism is warranted for any fundamental belief we may form, and having a risk team that looks impartially at our assumptions is critical to navigating potential regime shifts.

Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the Value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.