By Jack Forehand, CFA, CFP® (@practicalquant) —
In my last article, I took a look at the overall market valuation and the relative and absolute valuation of value stocks using our market valuation tool. Although my natural inclination towards value investing leads me to focus on it more than I should, it is obviously only one of the major investing factors. So I thought it would be interesting to take a look at the other factors to see where they stand from a valuation standpoint.
As I discussed in my previous article, we look at both absolute and relative factor valuations and use a median rather than a mean to do it. Since I covered the pros and cons of that in the previous article, I won’t do it again here, but you can refer to that article if you want to understand them in more detail.
For absolute valuations, we look at the 20% of our database that scores highest according to the factor and look at the median valuation of that group. For example, if we are looking at the value factor, we use the 20% of stocks that are cheapest. If we are looking at momentum, we look at the 20% with the best one-year returns. We then compare that group’s current valuation to its own history. For relative valuations, we compare the valuation of that group to the 20% of our database with the lowest score using that same factor.
Here is what the valuation of each factor looks like as of today using our system.
Absolute Valuation: Mixed
Relative Valuation: Very Cheap
As I mentioned in my previous article, whether value is cheap or not on an absolute basis really depends on the metric you use.
Using the PE ratio, value looks relatively cheap, as rising earnings have improved valuations. It is currently in the 11th percentile using this metric.
But using Price/Sales, it looks very expensive just like pretty much everything else does.
Using Price/Cash Flow, valuations are high, but not as high as Price/Sales, with the valuation currently in the 57th percentile.
Relative to growth (or to put it more correctly, expensive stocks) value looks extremely cheap no matter how you look at it. Here is the valuation using the PE Ratio. We are currently in the 2nd percentile for the period we have been tracking this since 2006. The only time value was cheaper in that period was following the 2020 bear market bottom.
Absolute Valuation: Cheap
Relative Valuation: Very Cheap
It might seem weird to see that momentum is cheap given the huge run the market has been on. But that result is a function of the ability of momentum to rapidly change in response to changing market conditions. For years before the COVID-19 crisis, momentum was very aligned with growth. But it is important to keep in mind that momentum only cares about whether a stock is going up. It doesn’t care about fundamentals. It also doesn’t care whether a stock is a growth stock or a value stock. That means that when market leadership changes, momentum will react to that. And with value stocks leading the market in the past year, it has made a strong pivot toward value. This has led to a big decline in the valuation of a basket of the stocks with the highest momentum.
Here is what the decline in absolute valuation looks like on a chart.
Below is what it looks like on a relative basis. Because of the rotation I talked about, the basket of stocks with the lowest momentum has been getting more expensive at the same time the basket of stocks with the highest momentum has been getting cheaper. This has led in a massive change in relative valuations.
It is important to keep in mind, though, that the relative valuation of momentum stocks can change just as rapidly in the other direction as they did here. If the performance of value stocks in the past few months continues, we could be looking at a very different situation in 6-9 months and momentum could be very expensive again.
Absolute Valuation: Above Average
Relative Valuation: Moderate, But Getting Cheaper
In an expansive market, you would expect quality companies to also be expensive on an absolute basis. And they are.
But an interesting thing has happened to their relative valuation in the market’s rebound off the March 2020 bottom. That rebound has largely been driven by low quality companies, which has made high quality companies more attractive on a relative basis. As I pointed out in a previous article, there are significantly more quality companies among the cheapest companies in the market than there were 18 months ago.
Here is what the valuation of high quality stocks looks like relative to low quality stocks. High quality has become more attractive on a relative basis.
Absolute Valuation: Expensive
Relative Valuation: Expensive
Low volatility stocks had a great decade leading up to the beginning of 2020. Then they had a very rough run for a year or so, which made them more attractive, at least on a relative valuation basis. But in the most recent few months, they have returned to their winning ways, and their valuations have risen in the process.
Here is what their current absolute valuation looks like on an absolute basis. It is in the 95th percentile.
And here is their valuation relative to high volatility stocks.
In both cases, they look expensive.
The Limits of Valuation
As I mentioned in my previous article, none of this data tells us anything about what is likely to happen in the next year. It doesn’t even tell us much about what might happen in the next three years. Valuation data is much more useful as a guide in looking at a potential range of long-term returns than it is as a timing tool. So even though this data might give value investors reason for optimism and low volatility investors reason for pause, it says nothing about which factors will lead the market in the near-term. I will update this data every few months to see how things evolve over time.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.