Established stock market truths are a funny thing. Case in point: For more than 30 years it has been an accepted fact that value stocks outperform growth stocks. Scores of graduates have learned this as part of their finance catechism.
And half of this time it has been factually wrong.
MSCI has split its World Index in two.
Roughly speaking, one half contains moderately priced value stocks, measured by traditional multiples, while the other half contains growth stocks, with presumably higher growth expectations and higher pricing.
With these sub-indices we can produce another index showing the relative performance of value stocks vs. growth stocks. This index peaked as far back as in 2006, exactly 15 years after a curriculum classic written by Eugene Fama and Kenneth French documented the historical outperformance of value stocks. In the subsequent years, this relative index has declined, sometimes sharply.
Why? My best guess would be the steadily falling interest rates. Lower interest rates reduce the discount for earnings far into the future.
But guesses, albeit based on standard economic precepts, are nothing to go by. A better bet would be a straightforward regression, using yields on 1-year and 10-year US Treasury bonds as independent variables – presumed causes, that is. We have no global interest rates, but the US stock market is a major part of the world index and US interest rates weigh heavily on other countries' rate levels.
This simple model explains more than 65 per cent of the variation in relative performance, as measured by the so-called coefficient of determination. The 10-year Treasuries are by far the most important, and the 1-year Treasuries are not significant, so a better description would be that the 10-year Treasuries single-handedly explain 58 per cent. Either way, it is obvious that the relative performance of value vs. growth is a function of interest rates. Over the years, interest rates have come so far down that growth stocks have been getting a real boost. In keeping with my initial metaphors, they've been appropriately greased.
But wait, there is more.
With the exception of some notable setbacks, stock market pricing has increased considerably, at least nominally and on average. This, however, is entirely due to higher pricing of the already highest priced stocks. Figures that I've downloaded from Kenneth French's homepage show that Price/Book ratios have almost doubled for the most expensive decile, while pricing for the lowest priced decile has remained unchanged.
The upshot is a growth tilt for cap-weighted stock market indices. When its market cap increases simply because a stock gets higher pricing, it also increases its index weight. More precisely, the partial effect of higher market capitalisation is higher weighting in an index that is weighted by market capitalisation – as are all the major indices.
See? Not only have value stocks struggled because of falling and low interest rate levels. Active managers, having been overweight value stocks, at least in the US and the Norwegian market, have had the same kind of headwind.
Each year, the index producer S&P Dow Jones Indices publishes a scorecard for active managers vs. their respective indices. Measuring all American funds against the wider S&P Composite 1500, we again see that 2006 became some sort of watershed. During the previous five years, the outcome was just about 50/50; during the next 15 years, almost two out of three funds had negative excess returns.
“As both value stocks and active managers have now experienced a weak streak for one and a half decade, falling and low interest rates are an important part of the explanation on both counts.”
In this case, we only have one lap time a year, limiting the inferences we can draw, and the connection seems to be somewhat weaker. Nevertheless, the 10-year Treasuries alone deliver a coefficient of determination of 30 per cent. Since we now only have one independent variable, this corresponds to a correlation of 55 per cent. That's quite impressive for two series that, on the face of it, have nothing to do with each other.
Did this get very technical? The point is simply this: As both value stocks and active managers have now experienced a weak streak for one and a half decade, falling and low interest rates are an important part of the explanation on both counts.
After the relative value index peaked in 2006, yields have fallen by about 5 percentage points on the 1-year Treasuries (approaching zero) and 3 percentage points on the 10-year Treasuries. If this were to continue, we will end up deep in negative interest rate territory. Would you bet your own money on this happening?
