Nomura: This Is What Is Holding Back Value StocksRupert Hargreaves
Over the past 12 months, according to Bank of America Merrill Lynch, valuation dispersion in the S&P 500 has returned to the highs not seen since the financial crisis. This has helped active managers outperform. Indeed, as ValueWalk has already reported several times this year, more than two-thirds of actively managed funds have beaten their benchmarks over the past six months, making this period one of the most successful on record since the financial crisis.
However, against this backdrop value stocks have struggled to keep up with the rest of the market, while growth stocks have provided most of the returns. Analysts from Nomura’s quantitative investment strategy team, believe that the reason why value has struggled to outperform growth in recent years has a lot to do with the attractiveness of cash.
In a recent report on the topic, quant analysts Joseph Mezrich and team note that over the past 12 months, the best performing factor in the Nomura quant database has been the cash/assets factor, meanwhile, value-focused factors have struggled to keep up.
According to data compiled by economist Robert Shiller, interest rates hit the lowest point in 147 years at the beginning of July 2016. Starting in 1981, interest rates declined steadily over a period of four decades to this point. However, over the past 12 months this trend has dramatically reversed, and since July 2016 the 10-year Treasury yield has doubled. According to Shiller’s data, this is the most substantial percentage rise in bond yields over any 20 month period since 1871.
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According to research compiled by Nomura, this shift has favored stocks with a high level of cash compared to assets. Indeed, the analysts state that an equal-weighted portfolio going long the decline of high cash/assets stocks in the Russell 1000 and shorting the low decline has returned 47% since early July 2016.
What’s interesting is the fact that over the same period, the relationship between values stocks and inflation has broken down. Historically, when interest rates rise, and inflation picks up, value stocks have benefited from a tailwind of economic growth. But this relationship has completely broken down since July 2017. According to the analysis, since July 2017 the book/price factor has dropped by 10% while the 10-year breakeven inflation rate climbed 40 basis points.
Nomura’s quant team speculates that this relationship breakdown can be traced to levels of cash. Growth stocks have always had higher levels of cash compared to assets than value stocks. Between January 1972 through February 2018, Nomura estimates stocks in the Russell 1000 Growth index held roughly twice as much cash as a percentage of assets than stocks in the Russell 2000 value index. The continuing failure of value stocks to stage of recovery in the face of positive economic growth, suggests that the economic growth benefit to value is “inferior to the cash/assets benefit to growth stocks when cash/asset returns are as large as they have become.” Even though economic growth is a positive tailwind for stocks, it has not proven to be as beneficial as the reward to cash/assets.
Even though the rise in rates over the past 12 months has been one of the fastest ever recorded, this relationship has appeared in the past. Nomura’s data shows that since 1990 the return correlation between book/price and cash/assets tends to become entirely negative (less than -0.6) when the 10-year Treasury yield rises substantially over a 20-month period.
The report goes on to point out that since March 2017, the success of growth over value has shared a familiar trajectory with the return to the cash/assets factor. In other words, ” the reward to cash/assets has become tightly connected to the failure of value to beat growth. Measures of growth vs. value closely track cash/assets since March 2017.”
Added together, this data points to the conclusion that despite the broad global economic recovery and improving inflation value is still struggling, whereas growth is not. Rapidly rising interest rates could explain why this is the case. Higher interest rates have made the cash/assets factor more attractive to investors and has become a potent source of return. As growth stocks typically hold a higher level of cash and value stocks, growth has continued to dominate value, despite the economic backdrop, which favors the latter. Therefore the rate of increase in interest rates is a headwind for value and when the rate of increase declines substantially, “the power of cash/assets should stop being a headwind for value” Nomura’s report concludes.