November 10, 2019
THE VALUE ROTATION IS ON
Value stocks, as a factor, are often categorized by the “cheapest” stocks in a market, based on metrics such as low Price to Book (P/B), Price to Earnings (P/E), or Price to Sales (P/S) ratios. This group is on the opposite end of the spectrum from traditional growth stocks, sometimes referred to as momentum stocks, which tend to have higher valuations due to their perceived higher earnings growth rates.
Typical value industries are considered to be economically sensitive, and more mature in their growth stages, often called cyclicals, such as semiconductors, industrials, airlines, banking and financials, steel and copper, trucking, energy, and health care, to name a few.
PRICE TIPS IT’S HAND
1. First and foremost is always price action. The rotation as we know it started on Monday, September 9 (see screenshot below) as many cyclicals were up 4-5%+ on the day and momentum names were down en masse, some down over 10% for the day. That was the first notice that a massive sector/factor rotation may be under way. When there is a major move of this magnitude across various industries, it is a clear sign from the markets that something may be “different”. The old market adage is they don’t always “ring a bell” at major market turns, but indeed, sometimes they do. They definitely rang a bell here, for those of us who focus on price action.
What was also noteworthy, is that the trailing 12 month worst performers were up significantly for the week, while the year’s best performers sold off sharply, another classic sign of rotation. (see screenshot below)
2. Second, from a quantitative measure, value is as “cheap” now as it ever has been historically vs. “expensive” stocks. Reversion to the mean dictates that at some point these factors will start to come in, value up, momentum down. That process appears to have started.
The chart below from AQR, used with permission (see footnotes), tracks the “value spread” which seeks to identify how “cheap” value stocks are versus history, by sorting stocks on value characteristics, and then quantifying the spread between the “cheap” and “expensive” stocks. As the chart shows, the spread just registered the highest of any other time period than the 1999/2000 Tech Bubble. AQR’s piece is an exceptional read, and is a very comprehensive analysis of the value spread.
The graph above shows how historically “cheap” value is currently, and any reversion to the mean could be a longer-term process. Markets are not perfectly efficient, and often overshoot to the upside and downside.
The reason I list the valuation metrics as second, is that ratios and valuation metrics can continue to extremes for extended periods of time, but until the market starts to actually adjust, the ratios alone are not enough for me to alter positions. Once the move itself starts, it pays to understand what other market forces may be in play.
3. Third, as the stock market is a discounting mechanism, some pundits opined in September that the massive momentum stock decline was a signal of slower economic growth ahead, and that it was a negative development. My view on that day, which I stand by today, is that the market is forecasting better growth ahead, and was moving into the cyclical names in anticipation of better economic growth. When growth is perceived to be scarce, the market pays up for the few industries that it believes will provide growth, which can drive prices up in momentum “growth stocks”, which in this cycle was in the SaaS software space. The economic growth outcome still remains to be seen, but I stand by my initial thought process of reading the rotation into cyclicals as a positive sign.
4. Fourth, as we bring this full circle, is back to price, are strong price breakouts across the board. Traditional value/cyclical industries have been breaking out en masse to new 52 week or longer highs. Semiconductors, which are very cyclical, have been leading this recent move to new highs and have been the strongest tech sector on the screen for the last 90 days. Industrials, banks and brokers, heavy construction, home builders, rails, trucking, oil refiners and other traditional value groups and countries with lower price to book readings than the U.S., are making new highs. Japan, Russia, Taiwan, Germany, EAFE are all on the recent new highs list.
In trading, I focus on price action and react to the message of the market without trying to make a longer-term prediction. Identifying that a major move may be under way is not the same as predicting it’s continuation. In trend following, trend identification is not the same as trend prediction. Identifying a trend and getting into it is not the same as predicting with any certainty that the trend will continue.
NAMES OF INTEREST
I use a proprietary, data driven method to rank stocks and ETFs, based on technical and quantitative metrics. Groups that I like here are many, starting with Financials. Financials are the largest component of the CSRP U.S. Large Cap Value Index, and are also ranked very high on my ETF momentum list. They also have the lowest price to book readings here. Emerging markets, Europe and Japan are very cheap vs US. EEM Price to Book 1.70, EWJ 1.85, VGK 1.9 and SPY is 3.12. Semiconductors, which are one of the more cyclical industries, continue to lead, and have been my highest ranked tech sector for the last few months. Deep cyclicals like industrial metals, basic industries, and rails & trucking are acting well also. European financials are one of my favorite long-term turnaround groups here, with SCGLY and DB especially showing signs of long-term trend reversal. I think the biggest potential upside could come from the industrial metals group, steel and copper, also from energy services and European financials.
Longer term names of interest are:
Financials: JPM, BAC, PNC, C, GS, XLF
Semiconductors: AMD, ASX, MU, NVDA, SMH
Regional Banking: FITB, RF, USB, KRE
European financials: BCS, CS, DB, SCGLY, UBS, EUFN
Industrials: CAT, DE, GE, HON, XLI
Pharma: AGN, BMY, TAK
Industrial Metals: AA, AKS, FCX, MT, SCCO, X, XME
Energy: I am sticking with the ETF’s XOP or XLE for now, due to the weaker energy stock charts and the strongest names on my screen are the refiners PSX, VLO and MPC. Most of the energy stocks on my screen are buried in a downtrend or too far below their 200 day moving average and don’t fit my process currently.
Rails and trucking: KSU, PCAR, JBHT
Japan and Japanese banks: SMFG, NMR, MFG, EWJ
Consumer: KHC
The ETF VLUE is a higher volume way to participate in the group without the single stock risk.
BANK OF AMERICA (BAC)
HONEYWELL (HON)
ALCOA (AA)
KRAFT HEINZ (KHC)
S&P METALS & MINING ETF (XME)
UBS (UBS)
All stocks have risk and these turnaround names can be very volatile, with wide swings and sharp pullbacks that often test stop levels. This move may not follow through and they could all turn back down at any time as well. As stated before, identifying that a move is under way is not the same as predicting or forecasting it’s continuation. Key levels for all would be to hold the most recent lows and I use a 10 – 12% standard stop level on all positions to limit downside.
SUMMARY
The Value rotation is underway. Whether it continues or not remains to be seen. Price has started to move, value is historically cheap, and value industries are leading to new 52 week plus highs, and some are showing signs of long-term trend reversal. All are bullish technical signals. Market don’t always move in straight lines, and there are always pullbacks, but technically the positioning here is bullish for now in these groups.
Footnotes:
Used with permission:
https://www.aqr.com/Insights/Perspectives/Its-Time-for-a-Venial-Value-Timing-Sin
