EC Is The End Of The Value Trade Near?

Compounding the problem of accounting issues is surging corporate debt levels, and the issue becomes more apparent. Given the Federal Reserve’s monetary injections and suppression of interest rates, companies heavily leveraged their balance sheets. As interest rates plunged, corporations issued a record amount of debt to pay dividends and increase share repurchases.

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End Value Trade, #Technically Speaking: Is The End Of The Value Trade Near?

The increased leverage of corporate balance sheets is problematic, particularly given already weak revenue growth for S&P 500 companies.

 

Be Careful What You Wish For

While there are many expectations that further rounds of stimulus will promote a short-term pick-up in economic growth, that may also be a problem for the value trade. As noted above, the “value” trade works best coming out of a weak economy and late-stage bear markets.

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End Value Trade, #Technically Speaking: Is The End Of The Value Trade Near?

While the U.S. certainly experienced a “recession” due to a “pandemic-driven” choice to “shut-down” economic activity, the recessionary cycle was not allowed to complete the normal process of reverting valuations. As shown in the chart below, it is hard to suggest a “margin of safety” currently present.

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End Value Trade, #Technically Speaking: Is The End Of The Value Trade Near?

As noted, the hope is that economic growth will rise strongly enough for earnings to catch up with prices. However, if market participants get their wish of increased economic growth, both inflation and interest rates will rise in lockstep. Such would undermine earnings growth and valuations as higher costs reduce profit margins.

The Dollar Problem

Then there is the dollar. The recent rotation to value has been primarily a function of a “weaker dollar,” which boosts commodities. As noted, if economic growth does strengthen, leading to higher rates will attract foreign inflows into the dollar for a higher yield. Such also undermines corporate profitability, given that roughly 40% of corporate profits are from abroad.

Such was a point made by JP Morgan just recently:

“The USD and yields have shifted from a negative correlation to a positive correlation, with the bank suggesting that recent USD strength may be driving some of the recent weakness in commodities.”

End Value Trade, #Technically Speaking: Is The End Of The Value Trade Near?

The risk not factored into the current “value” trade is the inflation and interest rate increase due to the massive amounts of stimulus. However, that stimulus will quickly flow through the system, leaving consumers tapped by higher inflation and rates eroding disposable income.

In other words, the “value trade” could be just a fleeting as the “economic recovery” itself.

 

No Real Correlation

As Michale Lebowitz recently penned for our RIAPRO.NET subscribers (30-day Free Trial):

“Does value beat growth in a rising yield environment?

At first blush, we would answer with a resounding yes. Our justification is value companies tend to use less leverage making profits not as sensitive to higher interest rates.

To help answer the question, we assessed nearly 100 years of data courtesy of Dartmouth (French/Fama). We created several statistical models and found no significant correlation between the value/growth trade and yields.

It turns out the task was simpler than we thought. All we needed to do was compare a value/growth index versus 10-year yields. The answer: value consistently outperforms growth, regardless of the rate environment.

The red shaded area denotes the last environment with consistently higher yields. The green period highlights the yield decline over the previous forty years.  The second graph shows rolling five-year annualized returns of value versus growth.”

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