A Closer Look at the Recent Market Rotation | Lord Abbett
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Equity Perspectives

For all the talk of a growth-to-value shift, we think investors would be better served by focusing on the longer-term themes of innovation, durability, and vulnerability.

Read time: 5 minutes

Positive news on COVID-19 vaccines from Pfizer/BioNTech and Moderna in the past several days has raised hopes that life as we once knew it may return in some form as early as next Summer or Fall. That reality sparked a sharp, multi-day rotation in U.S. equity markets last week, which some have labeled the beginning of a long-anticipated growth-to-value shift, and, potentially, a revival for small caps.

Looking at last week’s stark differentiation—a greater than 10% performance spread between the Russell 2000® Value Index, representing small cap value stocks, and the Russell 1000® Growth Index of large cap growth names—there was a notable short-term shift in the U.S. equity markets. While a larger, longer-lasting rotation is certainly a possibility, we would caution investors from making sudden and significant changes to their asset allocations.

 

Figure 1: The Start of a New Value and Small Cap Regime—or Another Market Head Fake?
Index performance, November 9–13, 2020

Source: Bloomberg. Data as of November 13, 2020.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is not a reliable indicator or guarantee of future results.

 

  1. Innovation has thrived for years through COVID-19. Is it overdone?

We’ll offer a sneak preview of question #2 below by asking “relative to what”? Do areas of high innovation have higher price-to-book (P/B) ratios and high price-to-earnings (P/E) ratios compared to the broader equity market? Yes, absolutely. Are many high-innovation companies that are participating in secular trends that may still be in relatively early stages—think e-commerce, artificial intelligence, electric vehicles, and genomics—undervalued relative to the growth they will create over the next decade?  We believe again, yes, absolutely.

As we discussed in a recent paper, we believe many of these types of asset-light, high R&D-intensity companies are greatly misunderstood when viewed through the formulaic lens of value investing. In some cases, we think these companies are among the cheapest stocks in the market relative to what they will create in the years ahead. Undoubtedly, these companies can endure periods of short-term underperformance relative to Value. Further, the dynamism inherent in areas of innovation requires active monitoring and portfolio positioning of winners and losers within industries that are characterized by rapid change. However, attempting to call an end to the technological revolution and innovation itself is, in our estimation, a recipe for failure.

In an economy that has become better defined by innovation, durability, and vulnerability (rather than growth vs. value), we believe innovation has evolved to a core equity asset class for investors today—one that is necessary to generate returns that meet long-term investor goals. Their game-changing technologies and business models put them into a position to seize market share from less innovative companies—the “vulnerable” firms in the tripartite dynamic mentioned above. 

  1. Are Value stocks undervalued?

Institutions and individual investors have wrestled with this question for years. The P/E and P/B ratios of many Value stocks look inexpensive (the primary reason they are labeled as Value stocks by index creators in the first place), but as with any discussion about valuations, the real question is “relative to what?” We think today’s Value universe has a wide range of companies—for example, highly cyclical industries such as Financials, Industrials, and Energy that have been depressed for years thanks to a low GDP growth environment. These segments of the economy were the impetus behind the November 9–13 Value rally. If recent vaccine news signals a rising possibility that the pandemic crisis will ease by mid-2021, we think these stocks may have more upside ahead.

The Value indexes also contain stocks that we would characterize as truly durable, solidly performing companies that have successfully staved off the threat of disruption from innovation and appear to be well-positioned for the decade ahead, in our view. Think of resilient areas such as dollar stores, dominant global brands in entertainment and experiences, and modest growth industries that have adapted their businesses successfully to e-commerce.

Lastly, there are the value traps. These are stocks that tempt investors with apparent cheapness and the appearance of a “margin of safety” in their low valuations. However, we believe more and more companies in this group are cheap for a reason—they face existential risks of displacement by innovation, like the nearly 150 bankruptcies we’ve seen this year in retailers that have failed to adapt to e-commerce.  Most of these listed COVID-19 as the reason for their bankruptcy filings, but in all cases, their demise was likely already in the works; the pandemic just accelerated the inevitable.

We believe there may be many durable names in the Value indexes that can deliver strong investment returns in the years to come and should benefit in the near term from the end of the pandemic. However, in our view, investors would do well to know what they own in their value funds to ensure they are owning durability rather than vulnerability.

  1. As we emerge from COVID-19, how should we think about allocations to innovation and durability?

Coming into the 2020s, we had already envisioned something of a more Darwinian decade ahead in the U.S. economy, and COVID-19 has only amplified this divide.  Combined with the effects of globalization, innovation has created an economic environment of creative destruction, with starker differentiation between winners and losers. Growth/Value was never an optimal framework for thinking about the entirety of the economy and opportunity set for equities. Now that technological innovation has unleashed an era of chronic disruption to business models and industries themselves, that framework, based primarily around price-book cheapness, makes even less sense.  Many stocks thought to be “cheap” at low P/B or P/E ratios may in fact be among the most expensive companies in the market if they are ultimately heading for zero. And conversely, the next Amazon.com out there may—as we said above—be among the cheapest stocks in the market if that company is going to conquer an industry.

A Final Word

As we think about the year and the decade ahead, we believe investors need to keep four concepts in mind:

  1. The pandemic is not over, and there are still unresolved political issues around the final makeup of Congress and the potential for stimulus related to the pandemic crisis. As such, the remote economy trade (as exemplified by the “work from home” stocks) may have more room to run in the near term.
  2. We believe a cyclical rotation is likely at some point in the equity markets, meaning investors should have some exposure to durable companies with solid track records for earnings and revenue growth that are more closely tied to the economic cycle.
  3. The longer-term narrative in the economy is that innovation is marked by formidable, long-lasting trends; we think investors need exposure to those trends in their portfolios. We believe these businesses are poised to win through organic growth and displacing less agile companies and industries.
  4. Attempting to time market shifts like growth/value, large/small, risk-on/risk-off with big tactical bets likely will lose you money over the long term. The more important exercise today is to “know what you own” in your growth and value allocations. To drive the point home one last time, we believe that means owning innovation and durability, and shedding exposure to vulnerability.

 

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall.

No investing strategy can overcome all market volatility or guarantee future results. 

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize, or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Glossary and Index Definitions

Earnings per share (EPS) is a company’s earnings divided by the number of shares outstanding. EPS can also be computed for an index such as the S&P 500.

Formulaic value refers to investment strategies that use ratios of common fundamental metrics (e.g., book value, earnings) to market price to determine the perceived attractiveness of an equity investment.

The price-to-book ratio compares a company's market value to its book value. The market value of a company is its share price multiplied by the number of outstanding shares. The book value is the net assets of a company.

Price-to-Earnings Ratio: Stock analysts calculate a price-to-earnings ratio by dividing a stock's current price by its earnings per share on a trailing 12-month basis. A forward price-to-earnings ratio is calculated by dividing a stock's current price by estimated future earnings per share.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

The Russell 1000® Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.

The Russell 1000® Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.

The Russell 2000® Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values.

The Russell 2000® Value Index measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.  If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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