Serious Money: The bull market in global stock prices that began 3½ years ago has been led by "risky" assets of all varieties, from emerging markets and value sectors to high-yield bonds and small-cap stocks.
Value indices have outpaced growth stocks by more than 60 percentage points since 2000. Six consecutive years of value dominance has seen growth's valuation premium drop from a peak of almost 200 per cent to just 8 per cent today. But financial markets have reached an inflection point and, while stock markets have recovered from the swift but modest setback in May and June, changes are afoot beneath the surface. Indeed, conditions are now in place for traditional growth sectors such as consumer staples and pharmaceuticals to register a sustained period of strong relative performance.
The primary determinant of the relative valuation of growth and value stocks is the slope of the yield curve, which graphs the relationship between interest rates and the term to maturity of identical fixed income securities. Long-term interest rates have exceeded short-term interest rates 80 per cent of the time over the past 50 years.
In other words, the yield curve is typically upward sloping. Historically, the steeper the slope, the lower the valuation premium afforded to growth stocks. Growth has tended to trade at a discount to the market once the slope steepens beyond three percentage points. Conversely, the flatter the slope, the more investors have been willing to pay for a dollar of growth earnings.
The US yield curve is currently downward sloping. The yield available on 90-day government paper currently exceeds the yield on 10-year bonds by half a percentage point. An upward sloping curve is unlikely to arise without a meaningful reduction in short-term interest rates by the Federal Reserve, which is not on the cards for now.
A downward-sloping curve is apparent not only in the US but also in Australia, Canada and the UK. The curve is flat in the euro zone but is likely to invert with a further hike in rates by the European Central Bank.
However, growth trades at a modest 8 per cent premium relative to value on consensus estimates of forward earnings despite the yield curve slopes. Growth stocks are clearly cheap at current prices.
While the yield curve is the major driver of relative valuations, the relative performance of growth and value stocks is driven primarily by the trend in relative profitability. The key to market-beating performance in recent years has been to invest in those stocks with the largest increase in profits and expectations of future earnings thereof.
Not surprisingly, the best performers have been value sectors, primarily energy and industrial commodity stocks. Indeed, these sectors have added almost five percentage points to aggregate earnings growth over the past two years. Additionally, the rising prices of oil and other commodities have ensured that analysts' upgrades to earnings estimates have exceeded downgrades for most of the past three years. However, the profit outlook is deteriorating.
The price of energy and other commodities is declining. Indeed, oil prices have declined from an all-time high of $78 a barrel in July to below $60 in recent sessions, the largest price drop in 15 years. Other commodities have followed suit.
More importantly, global economic growth is set to slow from its heady pace of recent years, bringing the extended cycle of profit upgrades to an end. The US economy has already slowed and the rest of the world is not far behind. The American consumer is under pressure not only from a difficult housing market but also a deteriorating employment outlook. The sharp and swift downturn to embrace the housing market has precipitated a recession in construction-related industries, which have accounted for more than one-quarter of all jobs created in the past 3½ years.
Ford has announced the largest production cut since the 1980s and 14,000 jobs, or more than one-third of its domestic workforce, is set to go.
Those who believe a consumer slowdown in the US will have a limited impact on global growth given the emergence of the middle-classes of China and India should think again. The American consumer accounts for one-fifth of the world economy - twice the size of Japan, the world's second largest economy, and three times as large as Germany.
Capital investment is also on the verge of a slowdown. A slowdown in capital spending by American business typically occurs no later than six months after a slowdown in consumer spending. Surveys suggest this cycle is no different - the number of small and mid-sized American companies intending to add capacity has dropped to the lowest level in more than three years. More importantly, China is determined to slow investment spending, which ensures the global economy will lose the two most important props of growth in recent years.
The appeal of growth stocks has dropped in recent years so allocations by investors are at multi-year lows. The valuation premium afforded to growth sectors on trend earnings is also close to record lows.
However, the underlying fundamentals no longer support value stocks. Indeed, the current narrow valuation spreads typically occur towards the end of a monetary tightening cycle and are followed by excellent relative performance from growth sectors. Cyclical stocks should be sold and monies switched to traditional growth sectors.
Charlie Fell is an independent consultant and lectures in finance and investment at UCD and the Institute of Bankers in Ireland.
