US Equity Market Rotation: Intact and Sustainable
As a follow-up to our December 2020 piece, "Time for a Great Rotation in Equities?", we note that equities have experienced a powerful rotation since Pfizer announced its enormously successful stage-three vaccine trial results on November 11, 2020 (Figure 1), with value and cyclical stocks taking over market leadership from secular growth segments.
Equity market performance in 2020 was dominated by the so called "stay-at-home" trade with the FAANGM1 stocks up an average of 55% versus 18.4% for the S&P 500 index. Value and cyclical stocks trailed by massive margins in 2020, with the Russell 1000 Value up just 2.8%, while the S&P 500 Financial and Energy sectors were down -1.7% and -33.7%, respectively. But last year's losers are shaping up to be this year's big winners. We believe the factors supporting this rotation are compelling and likely to continue throughout 2021 and perhaps beyond.
Figure 1: A Powerful Rotation Toward Cyclicals and Value Stocks
Factors supporting the continued outperformance of value and cyclical stocks include the following:
- Unprecedented Government Policy Stimulus: Both monetary and fiscal policy are off-the- charts stimulative. US federal government outlays were up a record 50% in 2020, eclipsing the 41% increase reached in 1968, and more spending is on the way in 2021. Action by the Federal Reserve has been far more forceful and timelier than in the aftermath of the Global Financial Crisis. Further, the Fed is pledging considerable patience in exiting emergency policy and is targeting inflation overshoot to compensate for inflation undershooting its 2% target in the past. As of April 28th, Cornerstone Macro estimated the combined amount of US fiscal stimulus and central bank liquidity injection at an eye-popping $12.3 billion, or 57% of US GDP.
- Booming Economic and Corporate Profit Growth: The unprecedented level of policy stimulus, combined with economic reopening and widespread vaccine administration, is unleashing a wave of economic growth not seen in the United States in decades. Real GDP growth is forecast to rise by 6.5% in 2021, according to the Bloomberg consensus. That may be too conservative, in our view, as some of the more bullish economic forecasters we follow and respect are estimating real growth in the 8%-9% range.2
Likewise, corporate profits are growing at a blistering pace. Currently, corporate profits for the S&P 500 index are expected to rise by 35% for calendar year 2021, but that estimate has been rising, and we expect it will rise further (it was 26% on April 1st and 23% at the start of the year). Positive earnings surprise for the current reporting season (the first quarter of 2021) has been absolutely massive, with 87% of the companies beating analyst estimates and actual results coming in at 50% year-over-year versus 24% expected at the start of the reporting season. The earnings surprise factor (the amount by which actual earnings beat analyst estimates) has averaged 20% over the past four quarters. Value stocks typically outperform when earnings growth is strong, whereas Growth stocks typically outperform in a weaker earnings environment, as investors bid up the stocks of companies that are able to produce steady earnings regardless of the macro environment. Finally, large-cap value stocks are expected to produce faster earnings growth (31%), rebounding from the slump last year, versus 21% for their growth brethren, which benefited from demand pulled forward by the pandemic, over the next 12 months.3
- Rising Inflation Pressure: Massive policy stimulus, huge pent up demand, and supply shortages stemming from the economic lockdown and subsequent reopening are sparking rising prices across many markets. Shorter-term inflation dynamics are being driven by base effects (abnormally low levels of inflation from a year ago during the peak of the lockdown) and supply/demand imbalances associated with the economic reopening and massive stimulus. The real test for whether this burst of inflation is transitory or more persistent depends on whether and how policy makers react once the economy has returned to full employment. The risk is that inflation expectations become unmoored and result in a vicious cycle of rising prices. We will discuss these issues at length in an upcoming white paper.
Here it is sufficient to note that periods of high and/or rising inflation have favored Value stocks and thus are another tailwind for the equity market rotation. In a recent note, Jonathan Golub of Credit Suisse observed that "pro-cyclical groups outperform as inflation rises, with Small-Caps, Value, Financials, and Cyclicals leading." In a trailing one-year analysis based on the five-year breakeven rate from the TIPS market, he calculates average daily returns for the Russell 2000 (0.66%), Russell 1000 Value (0.53%), and the Russell 1000 Growth (0.40%) on days when inflation expectations rise. Rising inflation also typically coincides with rising interest rates, which tend to weigh more on the multiples of longer-duration Growth stocks.
- Value Is Still Cheap and Coming Off More Than a Decade of Underperformance: If we are correct, and the cycle has, indeed, turned, it’s likely early days in the outperformance of Value. As shown in Figure 2, style cycles tend to move in multi-year waves. The latest Growth cycle was particularly long at 14 years! As a point of reference, the last Value cycle lasted eight years (2000-2007), however, the most explosive period of outperformance was during the first two years. With Value outperformance beginning last September, we are just nine months into a Value phase. Meanwhile, Value continues to look cheap relative to Growth on a relative PE basis. Growth stocks typically sell at higher earnings multiples, but the current difference in PE multiples is still more than a standard deviation above its historic average (Figure 3). That is, the PE for Growth is currently 31 versus 19 for Value, more than an 11-point gap compared to a long-term average of about 5.5.
Figure 2: Style Cycles Have Historically Moved in Long Waves
Figure 3: Value Is Still Cheap Relative to Growth
Our sector preferences also currently map cleanly to our style views. We prefer Energy/Materials and Financial stocks to technology/FAANGM stocks. The former segments are still cheap and likely to benefit from the economic surge. The Commodity sector has seen little investment in new capacity in recent years given the more-than-decade-long bear market in commodity prices and is now experiencing a positive, vaccine-driven demand shock. Like Financials, this segment is likely to benefit from rising growth and inflation pressures. Further, some materials (Certain Base Metals and Chemicals) that are linked to electric vehicles and renewable energy are supported by structural factors. Meanwhile, Tech stocks, and the FAANGM stocks in particular, are expensive and vulnerable to rising interest rates and rising regulatory/anti-trust risk. While we have focused on styles in this article, the broadening in equity market performance should also extend to small-caps and non-US equity markets, as these segments are also cheaper and more cyclically oriented.
1Facebook, Amazon, Apple, Netflix, Google, and Microsoft
2Nancy Lazar of Cornerstone Macro and Jan Hatzius of Goldman Sachs
3Russell 1000 Growth and Value indexes, as of 4/30/21