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Is the great rotation over already?

The Echelon Insights Team • Jun 28, 2021

Growth has been the dominant style for the U.S. equity market for pretty much all of the 2010s. Based on the S&P 500 style indices, growth beat value in every year from 2007-2020 with the exception of 2012 and 2016. That is dominance, and the cherry on top was a trouncing of growth over value in 2020 of +32.0% vs -1.4%. But in late 2020 the tide turned, and value started outperforming. All the stars were aligned for value including a sizeable valuation discount, the re-opening of the economy that would benefit value due to the constituents being more economically sensitive, rising yields and rising inflation. And it looked like the great value rotation had started… until the last few weeks cast some doubt. 

Starting in mid-May, growth began to outperform, rebounding from earlier weakness. Meanwhile value appreciation stalled. Of interest, this reversal coincided with bond yields following the same pattern. After rising since last summer, the yield on the 10-year Treasury fell from 1.70% to 1.42% a week ago. There is a pretty strong correlation between changes in bond yields and the relative performance of value and growth. 


The connection is logical. Bond yields tend to rise when the economic growth prospects are improving. Better economic growth benefits value companies more than growth for a few reasons. Firstly, value has greater weights in sectors that are more cyclical. Secondly, better economic growth means more companies are growing earnings; this reduces the scarcity of growth that sometimes occurs, favouring growth stocks.

 

Chart 2 is the 3-month percentage change in the 10-year Treasury yield and the 3-month relative performance of value vs growth. It is not a perfect relationship but the correlation is material and significant. So even though yields have come back down a bit, if you believe yields will rise in the coming months or quarters, value remains the better style tilt. 

There is also no denying the valuation gap remains elevated to the extreme between value and growth. Currently, growth is trading at 27.3x and value at 17.1x forward earnings. To be fair, index valuations are market cap weighted averages of the underlying company valuations. And averages can be very misleading. For example, a person with their head in the oven and their feet in the freezer, on average should be just fine. But we know that won’t work. 


A spread of 10 valuation points between value and growth is in the 98th percentile extreme based on the past twenty years (chart 3), meaning growth is very expensive compared to value. Add the yield outlook to the valuation spread, improving economic growth, improving earnings growth, inflation outlook, and these factors all favour value over growth. We believe this rotation, despite a short-term setback, is just getting started. 

Our View 

Time will tell if spending on travel / dining out and other activities we have not been allowed to do for the past year starts to crimp into spending on durables. Or spending on durables could normalize (aka contract from elevated levels) simply because if you bought a new sea doo or RV in 2020, you probably don’t need another new one in 2021. But so far people are simply spending freely on just about everything, and 2021 could still really surprise to the upside economically if this pace continues. 

Charts are sourced to Bloomberg L.P. unless otherwise noted.


The contents of this publication were researched, written and produced by Richardson Wealth Limited and are used herein under a non-exclusive license by Echelon Wealth Partners Inc. (“Echelon”) for information purposes only. The statements and statistics contained herein are based on material believed to be reliable but there is no guarantee they are accurate or complete. Particular investments or trading strategies should be evaluated relative to each individual's objectives in consultation with their Echelon representative. 


Forward Looking Statements


Forward-looking statements are based on current expectations, estimates, forecasts and projections based on beliefs and assumptions made by author. These statements involve risks and uncertainties and are not guarantees of future performance or results and no assurance can be given that these estimates and expectations will prove to have been correct, and actual outcomes and results may differ materially from what is expressed, implied or projected in such forward-looking statements.


The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Echelon Wealth Partners Inc. or its affiliates. Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. These estimates and expectations involve risks and uncertainties and are not guarantees of future performance or results and no assurance can be given that these estimates and expectations will prove to have been correct, and actual outcomes and results may differ materially from what is expressed, implied or projected in such forward-looking statements.


The particulars contained herein were obtained from sources which we believe are reliable, but are not guaranteed by us and may be incomplete. The information contained has not been approved by and are not those of Echelon Wealth Partners Inc. (“Echelon”), its subsidiaries, affiliates, or divisions including but not limited to Chevron Wealth Preservation Inc. This is not an official publication or research report of Echelon, the author is not an Echelon research analyst and this is not to be used as a solicitation in a jurisdiction where this Echelon representative is not registered.


The opinions expressed in this report are the opinions of its author, Richardson Wealth Limited (“Richardson”), used under a non-exclusive license and readers should not assume they reflect the opinions or recommendations of Echelon Wealth Partners Inc. (“Echelon”) or its affiliates.


This is not an official publication or research report of Echelon, the author is not an Echelon research analyst and this is not to be used as a solicitation in a jurisdiction where this Echelon representative is not registered. The information contained has not been approved by and are not those of Echelon, its subsidiaries, affiliates, or divisions including but not limited to Chevron Wealth Preservation Inc. The particulars contained herein were obtained from sources which we believe are reliable, but are not guaranteed by us and may be incomplete.


Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. Echelon and Richardson do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. These estimates and expectations involve risks and uncertainties and are not guarantees of future performance or results and no assurance can be given that these estimates and expectations will prove to have been correct, and actual outcomes and results may differ materially from what is expressed, implied or projected in such forward-looking statements.


Forward-looking statements are based on current expectations, estimates, forecasts and projections based on beliefs and assumptions made by author. These statements involve risks and uncertainties and are not guarantees of future performance or results and no assurance can be given that these estimates and expectations will prove to have been correct, and actual outcomes and results may differ materially from what is expressed, implied or projected in such forward-looking statements. 

Echelon’s Insight Team


Echelon’s Insight Team includes members in various departments such as Wealth Management, Capital Markets, Marketing, Talent, and Compliance who have subject matter expertise and collaborate together to build quality content to help our clients. This team approach helps us ensure content is produced that is meaningful, accurate and timely.

Labour Intensity, Wage Pressure, and Why People Are Quitting Their Jobs

By The Echelon Insights Team • 18 Oct, 2021
Inflation sucks. It is essentially a tax on those consuming goods or services, as things simply cost more. Even worse, it is a regressive tax given lower income/wealth consumers tend to spend a higher portion of their income. Now, if you are sitting comfortably on your nest egg and not spending too much, should inflation worry you? That depends on this raging debate as to whether the current spike in inflation is a blip caused by temporary demand and supply imbalances…or the start of something longer term. If inflation runs hotter for longer, the value of that nest egg erodes in real terms—clearly a risk to any long-term financial plan. Currently the good news is higher prices have been predominantly found in what the Atlanta Fed calls ‘flexible priced categories.’ Breaking down the categories in the Consumer Price Index (CPI) into those that are flexible and those that are sticky clearly demonstrates that the headline number is being almost completely pushed higher by the flexible categories. The good news is the prices in these categories can come back down just as fast, supporting the “inflation is transitory” argument. In fact, many have started this descent.  A confluence of factors caused the CPI spike. The pandemic disrupted logistic supply chains that have been increasingly run tighter over the years to reduce costs. Demand came back faster than expected and focused more on durable goods. Global spending behaviours changed quickly. Meanwhile supply adjustments are not as quick. Based on manufacturing survey data, it appears that the worse may be behind us. Readings are still high in many PMI survey questions, including slower delivery times, customer inventories too low, and backlogs rising, but they appear to have peaked a few months ago and are moving in the right direction.

Rarefied Air

By The Echelon Insights Team • 12 Oct, 2021
The market advance over the past year has truly turned a lot of heads, in a good way. After the initial bear and bounce triggered by the Covid-19 pandemic, markets went on a phenomenal run. The rollout of vaccines driving the re-opening trend in the economy helped, as did the continued emergency monetary and fiscal support policies. And what a run. During this advance, consumer spending pivoted much more to durables such as vehicles, homes, and technology. While nominal GDP doesn’t care as much where an individual decides to spend their money, the equity markets much prefer you buy some durables instead of services (like a dinner). 

Why we’re preparing for a turbulent year end

By The Echelon Insights Team • 04 Oct, 2021
Challenges ahead — Greg Taylor September has once again lived up to its reputation for volatility. In many ways this had to be expected as equity markets have experienced one of the longest runs of stable returns and minimal drawdowns in history. However, the timing of this recent volatility should not surprise many, as most of the positive tailwinds that have carried the market to these levels are starting to fade away, setting up what could be a difficult period for capital markets. Global central banks are the biggest and most important factor that have helped elevate recent returns. To their credit, they learned from the mistakes of the global financial crisis where indecision and delay exacerbated things—this time, right from the beginning, the banks did everything they could to help the markets and the economy. But all good things must come to an end, and 18 months after the start of the pandemic, it is time for central banks to begin to remove some emergency measures. This isn’t a bad thing at all. Central banks need to begin to normalize policy to prepare for the next crisis. But it is a change from the recent normal and means that central banks may be less accommodating for the next while. This action resulted in bond yields moving higher across the curve and has led to a change in sector leadership. The growth/value trade has been a subject of much debate over the last few years. As growth has dominated in a period of ever lower bond yields, with the threat of inflation, has this turned? Will the rally in energy be the trigger to get this going once again? The energy sector was a victim of the climate movement, but the resulting cuts to production may be setting us up for a bull market in the commodities as we are already seeing shortages in both natural gas and heating oil. The resulting price increases is also adding further ammunition to the inflation argument as higher costs will undoubtably flow through to the price of goods. What no one really expected in the month was the China risk. Consistently over the last year, China has been working to extend their influence over the capital markets, which has caused many to question if China is at all investible? Their constant clamp down on social media and other growth sectors became a secondary concern as their largest construction company ran into liquidity issues. Evergrande was never going to be a Lehman moment, but it had the potential to leave some scars. For the moment, this risk has faded to the background, but it can’t be ignored and has the potential to flare up once again. What could prove to be the biggest risk to the markets in the near term is earnings season. With the advent of quant funds gaining a greater market share, we have seen companies that beat earning expectations gain versus those that don’t. But as easy comparable estimates fade, huge beats will be harder to achieve. We have already seen some notable companies miss these expectations and the risk is that the next month will be filled with negative earnings revisions. One of the biggest reasons for earning misses has been from broken supply chains. Covid lockdowns and pulled-forward demand for goods did immeasurable damage to the concept of ‘just-in-time’ inventory models. Companies continue to scramble for components, such as semiconductors, in order to product goods. As indicated by the surge in used car prices, the automotive sector has been one of the hardest hit. Until this is fixed, we must expect inflated prices of goods and services and squeezing margins. Whether this is temporary or permanent is still up for debate, but its another headwind to markets.
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