US Equities are Pricey: How Should Investors Respond?
This is perhaps the most hated bull market of all time, with smart investors declaring, year after year, that the market is due (yet again) for a correction. For nearly five years, some investors have tried in vain to time market exposure, with lopsided short positions and heavy cash balances dragging on their returns. And yet the market keeps going up.
But there might be better, more measured strategies for placating fears of froth without foregoing the upside that an uncertain future can bring. Our research suggests that the most compelling strategy is to shift money from large-cap growth to small-cap value.
Large-cap growth stocks have been the engine of the current rally. Large technology stocks, like Google (trading at 17x EBITDA), Facebook (trading at 25x EBITDA), and Amazon (trading at 36x EBITDA), have dramatically outperformed the broader market, representing ever-larger portions of the market cap–weighted S&P 500 index and stretching valuations ever further.
This rally in large-cap growth stocks is anomalous relative to the longer-term history of the US market. Over long periods, small stocks outperform large stocks, and value stocks outperform growth stocks. But that has not been true for the last ten years. Below, we compare the performance of large-cap growth stocks to small-cap value stocks over the last three, five, and ten years to the longer-term 20- and 50-year history. We also show the size and value premiums, defined as the difference between the returns on small and large stocks and value and growth stocks.
Figure 1: Trailing Annualized Performance of Portfolios Sorted by Size and Value
Source: Ken French Data Library
Whereas over the longer term, small value has dramatically outperformed large growth, that has not been true for the last ten years. This anomalous performance has instilled doubt in even the most confident and successful of hedge fund managers. “The persistence of this dynamic leads to questions regarding whether value investing is a viable strategy,” wrote David Einhorn in a letter to clients of Greenlight. “After years of running into the wind, we are left with no sense stronger than ‘it will turn when it turns.’”
But the time-honored creed of believers in mean reversion remains: trends that can’t continue won’t. The outperformance of large growth stocks has driven the valuation spread between growth and value stocks nearly a full standard deviation from long-term averages. The below graph compares the book-market ratio of large-cap growth stocks to the book-market ratio of small-cap value stocks. Over long periods, large growth stocks have traded at about 5x the book-market ratio of small value stocks. Today, large growth stocks trade at about 6.4x the valuations of small value stocks.
Figure 2: Valuation Ratio of Large Growth vs. Small Value
Source: Ken French Data Library
The only other times in recent memory that this divergence has been as wide might have been at the depths of the financial crisis and the height of the tech bubble.
But how predictive is this ratio? We looked at rolling three-year performance of portfolios divided by size and valuation back to 1949. We divided the periods into quartiles based on the valuation ratio of large growth to small value. The top quartile, which is where the market is today, includes the most extreme gaps between large growth and small value.
Figure 3: Subsequent Three-Year Portfolio Returns Based on Valuation Ratio
Source: Ken French Data Library
Small value’s performance has been more consistent, whereas the performance of growth stocks has depended more on the valuation environment. If past is prologue, then there is now more than an 80% probability of a stretch of significant small value outperformance.
The situation at the height of the tech bubble is instructive. In 2000, small-cap value had experienced a long stretch of underperformance relative to small-cap growth and large-cap growth, similar to conditions today.
Figure 4: Trailing Performance of Factor Portfolios in February 2000
Source: Ken French Data Library
But over the subsequent three-year period, small value stocks returned 5.3% per year, even as large growth stocks suffered a three-year compounded return of -17.3%.
Market downturns—even sharp market downturns—do not generally affect all stocks equally. Today, we believe we are in a position reminiscent of 2000: the overvaluation is concentrated in large growth stocks, and small value stocks have had performance that has significantly lagged long-term averages.
Studying the history of the US market gives us guidance for how to react to periods of overvaluation. The answer is probably not to shift into cash and abandon markets altogether, but rather to shift into small value stocks and out of the large growth stocks that are driving the stretched valuations.