But it hasn’t always been this way, and Cliff Asness, the legendary founder of AQR Capital Management, has just published a paper designed to show that the recent correlation is a coincidence, or at best a phenomenon that will soon pass. Over a much longer time scale, this is how the “value” factor as defined by the finance professors Eugene Fama and Kenneth French has correlated over the last 90 years with the 10-year Treasury yield:
The correlation is very variable, and never particularly strong. However, it’s true to say that it appears to have been greatest, and most consistent, in the last decade or so. Treating value as a rates phenomenon is at least a reasonable response to the events of the last few years. The pattern shows up again if we look at the data in a scatter plot. There is a much stronger correlation over the last decade than over the years before, although the fit is still not that strong:
Asness balances the arguments as follows:
Basically, there’s grist for both sides’ mills here. Long-term there is very little evidence that the return of the value factor is anything other than trivially correlated to changes in interest rates. But, in more recent times, the correlation has been strong and in the direction hypothesized: When rates go up, value tends to do better and vice versa. Now we have to ask whether this correlation makes sense.
The argument for the link is that growth stocks’ value is piled up in cash flows a long way into the future, and thus they are a longer “duration” asset. In other words, a rise in interest rates, increasing the rate at which those future cash flows should be discounted, should have a much bigger effect on them than on value stocks. With rates plummeting during Covid, while optimism for internet platform groups intensified, by this logic it was natural that growth stocks’ valuation would surge relative to other companies. But can it be taken as far as the market has taken it?
This is Asness’ estimate of the spread of value stocks’ valuations compared to the rest. The higher the spread, the cheaper value is. Amazingly, value last year was briefly even cheaper than it was at the top of the dot.com bubble (whose bursting prompted a great few years for value). After correcting at the beginning of this year, value stocks are once again as relatively cheap as they were in the insanity of early 2000:
For a cruder illustration of the same phenomenon, the following chart shows the spread between the price/book multiple payable on prominent growth indexes, compared to equivalent value indexes. For years this spread steadily widened (meaning growth stocks grew more relatively expensive), and then the premium for growth stocks surged during the pandemic and its aftermath. The snapback that started at the turn of this year made obvious sense — and the rebound for growth in the last few weeks, which started when growth stocks still looked historically expensive, looks bonkers. Or, put more politely, it looks as though the market has provided another good entry point for those who want to buy value:
And yet, big investors don’t see it that way. The latest Bank of America survey of fund managers (of which more below), finds that for the first time since August 2020, a majority think growth will outperform value over the next 12 months.
How can they think this way? Jefferies equity strategist Steven DeSanctis points out that the relative rolling 12-month performance of value has ticked back up to the 87th percentile thanks to its strong performance at the start of the year. That prompts fear of a reversion to the mean, while the recession in housing could have a much bigger impact on value. “The decline and rebound has been more severe than average for growth this time around, while value’s rebound has been in line,” he says. “Investors just don’t want to give up on growth, as flows have picked up for the style while value continues to see outflows.”
Is this well advised? Asness accepts that the perceived correlation is so strong at present that lower rates would likely mean continued dominance for growth:
If something is trading a certain way, then on average it will continue for a while. Thus, while there are no guarantees, I expect this correlation to be around for a bit. But given that it’s likely either random or based on the same bubble reasons driving super wide value spreads, this all means that upcoming rate moves can affect the path of when (assuming I’m right about value spreads and the future!) value wins, but not whether it will win.
Does the hypothesis that value and growth are being driven by rates and duration really justify paying up hugely for growth stocks? Asness argues that it doesn’t, and that the whole idea rests on the notion that all growth stocks are in fact more like unicorns, whose earnings will explode into the future. The following chart is a work of genius:
Asness invokes unicorns, but I might call this the Amazon Fallacy. Amazingly, you could have made plenty of money by buying Amazon.com Inc. shares at the top of the dot.com bubble in 1999 and 2000. Lots of things were to break right for the company over the decades that followed, and it would also grab opportunities then unthought of, such as cloud computing.
But the point of Amazon is that there’s only one of it. Amazon was better run than the many companies that were trying to do much the same thing back in 1999, and went on to make lots of good strategic calls. It became so profitable and dominant because it eradicated the opposition and became a virtual monopoly in many of the things it did. Of its nature, the success of Amazon cannot be replicated by many at any one time. There can only ever be few startups that go on to build a large and well-defended monopoly. Asness’ point is that growth investors are behaving as though all growth stocks can be Amazon, and they can’t.
This is important, because by his math, the argument about duration and interest-rate sensitivity might make a little sense for true unicorns, but not at all for normal growth stocks. It’s worth reading his piece in full, but here is his exposition:
A duration of 10 years means that a 100 basis point fall in rates would, to a linear approximation, lead to a 10% increase in market value. If all three investments are assumed to have equal long-term expected returns… the “duration” of the growth portfolio (blue line) is 0.4 years longer than the duration of the value portfolio. If you think that’s trivial, you are correct.
Meanwhile, the unicorn in his hypothetical example would have a duration 10 years longer. It’s only when a company’s cash flows are tied up in massively higher earnings a very long way into the future that interest rates begin to matter to its current valuation. If investors in 1999 had had an accurate grasp of Amazon’s future cash flows, its share price should have been very sensitive to interest rate changes. But unless the growth stock you hold truly is a unicorn, lower rates really shouldn’t help it much compared to a cheap value stock.
Unfortunately, one of the few things we know for sure is that the great majority of growth stocks aren’t unicorns.
Not Apocalyptically Bearish
How are big investors feeling? They’re still bearish, according to Bank of America Corp.’s latest monthly global fund managers survey, but at least not “apocalyptically bearish” any more. That lack of capitulation in turn means that the current rally can continue; it will only end once all the bears have thrown in the towel.
The turnaround over the month stems from optimism that surging inflation has reached its peak, while global growth and profit expectations have rebounded from the all-time lows they hit in July, according to BofA’s strategists Michael Hartnett and Myung-Jee Jung. The survey, which included 250 participants with $752 billion under management in the week through Aug. 11, revealed that those overweighting equities and those expecting a stronger economy had both risen slightly from historically depressed levels:
The bank’s custom bull & bear indicator remains “max bearish,” which means its strategists see no immediate reversal of the bear market rally. “But we remain patient bears,” they said, adding that they would begin to exit the benchmark S&P 500 once it exceeded 4,328 (it closed Tuesday at 4,305), as “rates up-profits down” continues to be their base case.
To support BofA’s patient bearishness, a growing number of fund managers think the global economy will experience a recession in the next 12 months (58% from 47%, highest since May 2020 during the first Covid shutdown) and those who think inflation levels will decrease in the next year (highest since Global Financial Crisis).
US stocks have rallied since their June low, a point many perceived as the market bottom, buoyed by better-than-expected second-quarter corporate earnings and hopes that inflation in the US is finally cooling. That raises the hope that the Federal Reserve can reduce the pace of its interest-rate hikes enough to avoid a hard landing. JPMorgan strategists led by Marko Kolanovic, who has been stridently bullish of late, expect global inflation to slide to 4.7% in the second half of the year, half its current pace:
“Signs that a peak in inflation is behind are growing, which reinforces the idea that Fed hawkishness is likely behind and a soft landing is increasingly likely. The prospect of a recession in Europe is still very much alive, but this should be manageable so long as the US and China are still growing.”
It follows from this that the persistently high inflation would be the biggest “tail risk” confronting bonds and equities. And indeed, the BofA survey shows that stubborn inflation is now seen as more dangerous than a global recession, and remarkably, far greater than the war in Ukraine:
The survey revealed continuing caution as exposure to cash fell but remained well above the long-term average. But long cash also ranked third in investors’ nominations for the most crowded trade. Despite their recent pullbacks, the dollar and oil are seen as even more crowded.
Relative to the past 10 years, investors remain very overweight in cash and underweight in equities — particularly in the eurozone and emerging markets:
China’s real estate market is seen as the most likely catalyst of a systemic credit event, followed by Italian sovereign debt and US leveraged loans. Returning to tail risks, the following chart shows the full history of the survey dating back to 2011. The dominant themes are made clear by the color coding. One overriding lesson is that investors have a short attention span. The heightened tension between the US and North Korea in 2017 and the ongoing Russian invasion of Ukraine in 2022 both ranked as the greatest tail risk for only one month. Neither has been resolved, but for some reason they seem no longer to worry investors:
The purple streak, which reflects concerns of hawkish central banks worldwide, has been going on for more than a year. For all that stocks are rallying, investors are still worried about excessive zeal from central banks. And they should be.
Sentiment is in a strange place. In the short term, people are still too worried about inflation to flush out all the bears and bring the current rally to an end. But in the longer run, they’re right to be worried about price rises; there really is a big risk still that inflation doesn’t fall as hoped and central banks have to force a recession. The clearest conclusion is that equity prices are still very vulnerable to any nasty surprise on inflation.
—Assistance from Isabelle Lee
I’ve been sent some more examples of sportsmanship, and they’re inspiring. First, watch this clip from a girls’ softball game between teams from Washington and Oregon in 2008. The hitter whacks her first ever (and only) home run, but then damages a ligament rounding first base. If she doesn’t round all the bases it won’t be a home run, and no member of her own team is allowed by the rules to help her. So two members of the opposing team pick her up, and take her for a trip around the bases. Then there are times when fierce competitors can agree to share. The first London Marathon, in 1981, had two winners who crossed the finish line holding hands; and last year two high-jumpers agreed to share the Olympic gold medal. In cricket, in the Centenary Test between England and Australia in 1977, the great Aussie wicketkeeper Rodney Marsh called the English batsman Derek Randall back after he had been declared out by the umpire. Marsh knew he hadn’t made the catch — and Australia won anyway. Fast forward to 2005, and Australia oh-so-nearly triumphed over England only to lose by two runs; and the first reaction of England’s hero Andrew Flintoff was to console the Australian Brett Lee who had come so close. And it would be hard to beat the handshake at this year’s Tour de France between Tadej Pogacar, the two-time defending champion, and the yellow jersey and eventual winner, Jonas Vingegaard, who slowed and waited for Pogacar to recover from a fall, leaving himself open to a challenge from the only man who could beat him. Pogacar refused to press him for the rest of the day.
And for sportsmanship where these days it is all too rare, it can even happen in soccer. This is a compilation of players deliberately missing penalty kicks which they knew they shouldn’t have been given, along with a few strikers telling a referee not to award a penalty because they hadn’t been fouled. It would be nice if such things happened more often. They’re good for the soul.Like Bloomberg’s Points of Return? Subscribe for unlimited access to trusted, data-based journalism in 120 countries around the world and gain expert analysis from exclusive daily newsletters, The Bloomberg Open and The Bloomberg Close.
More From Other Writers at Bloomberg Opinion:
• Lionel Laurent: Greensill’s Ghost Will Haunt the Finance World
• Liam Denning: Buffett Made Occidental the Kind of Company He Can Love
• Andrea Felsted: Walmart Just Signaled the End of the Big-Box Bloodbath
(Updates with Tour de France link. An earlier version corrected the winner’s name toVingegaard.)
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of “The Fearful Rise of Markets.”
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