By Jack Forehand, CFA, CFP® (@practicalquant) —
We are in the midst of a market catastrophe. There is blood in the streets. There is panic selling. There are forced liquidations. And the S&P 500 is already down an astonishing ……… 8%.
Ok, I was obviously joking. But when you couple the fact that we haven’t seen a 5% decline in a very long time with the speed of this pullback, the situation tends to feel much worse than it actually is. The decline obviously could get much worse from here, but from where we sit today, we are far from the catastrophic situation the headlines might lead you to believe we are in.
But this has been an interesting decline for many reasons. And below the surface, the data shows some fascinating trends that I thought would be worth highlighting.
Here are four things I have found interesting about the market pullback this year.
[1] Value is Outperforming – Sort Of
One of the headlines you have likely seen during the decline is that value is outperforming the market. That would make sense given that the decline has largely been driven by growth stocks. And it is partially true. But it isn’t the whole story.
A look at popular value ETFs shows that some are beating the market by a wide margin, while others are actually trailing the S&P 500. What gives? The answer lies in their sector breakdown.
The chart below shows the YTD performance of the major sectors that are typically held by value funds. As you can see, whether a value fund is outperforming this year is essentially a function of its exposure to energy and cyclical value plays. The funds with the most exposure to energy are outperforming, while those with large exposure to consumer cyclicals are not.
[2] High Multiple Stocks Have Been Destroyed
This headline is just stating the obvious, but there is some interesting data behind the scenes.
Scott McNealy is famous for talking about the overvaluation of his own stock back when he ran Sun Microsystems and its Price/Sales got over 10. But a Price/Sales of 10 has been a value play in the growth space this cycle.
As of 12/31/2021, there were 583 stocks in our investable universe with a Price/Sales greater than 10. There were 200 with a Price/Sales greater than 30.
And it hasn’t gone well for these types of companies this year.
The average stock with a Price/Sales over 10 has lost 19% so far this year. The average stock with a Price/Sales over 30 has lost 23.5%.
Although I certainly wouldn’t say this decline has made valuations reasonable in the growth space, it has at least moved them in the right direction. The threshold to make the most expensive 10% of our investable universe based on Price/Sales has fallen from 30 to 20.3 in this decline.
[3] The Impact of Discount Rates
The idea that growth stocks underperform when rates are high since more of their value is in the future doesn’t hold up in the data like many think it does. The evidence of the relationship between rates and the relative performance of value and growth is mixed at best.
But understanding the impact of changes in discount rates on the present value of cash flows is important to understand when looking at why growth stocks can become much less valuable for small changes in rates.
Many of the growth companies that are being re-valued now won’t generate any cash flows for years. Their value lies well into the future, which makes that value very dependent on the discount rate used.
To use a very oversimplified example, assume we look at a company that will generate no cash flows for the next 5 years, but will generate cash of $1 in year 5 and grow those cash flows 20% in perpetuity after that. That company’s value falls 20% when the discount rate is increased by 2%. It falls 40% when the discount rate is increased 4%. Discount rates have major impacts on the value of companies when their cash flows occur mostly in the distant future.
[4] The Current State of Growth/Value Spreads
One question that popped into my mind right away when thinking about the compression of growth multiples was its impact on the spread between value and growth. But if you are a growth investor hoping that this decline has resulted in a significant change in growth’s relative valuation, the news I have for you isn’t what you have been looking for.
Here is the relative chart of value vs growth from 2006 to the present using Price/Sales.
That little blip to the right of the chart is the entirety of the change we have seen so far this year. Growth remains in the 93rd percentile historically relative to value. If you believe that relative valuations are going to normalize, we have a long way to go.
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.
