We are now, approximately one year from the start of the COVID-19 pandemic’s onset in the United States. In short, we remain in the midst of a stock market rotation away from “momentum” stocks fueled by COVID-related shutdowns and societal adaptations towards “value” stocks that remain historically cheap and consist of cyclical laggards. This “Great Rotation” started with the rise of bond yields illustrated by the 10-Year Treasury breaching 1.6%. The increase of yields at the longer end of the curve has been driven by additional stimulus accommodations with the $1.9 Trillion stimulus package likely to be approved. Underlying all of this is the simple excitement (or a degree of cabin fever) of economic normalization as vaccine mobilizations continue to increase with a new “one-shot” vaccine from Johnson & Johnson fueling further optimism. Therefore, the stock market rotation is a macrocosm of multiple economic developments.
Despite the March 9th recovery, the recent rotation out of technology stocks (and other growth stocks) and into value stocks has been on a tear since mid-February. But this should not come as a surprise. Throughout the pandemic, stock valuations became exaggerated, and high-growth stocks became the momentum and behavioral investing reaction to economic uncertainty. Economic uncertainty shined a “neon light” on disruptor companies. Industry disrupting companies thrive in environments of ample opportunity, and COVID-19 created the largest and most widespread industry opportunities. Our theory of “fast-forwarding” long-term consumer preferences and industry standards has been discussed on multiple occasions, but this process does not come without risks. “Fast-forwarding” industry innovation and forcing unprecedented adaptations can lead to inflated expectations of actual long-term impacts. For instance, will video communication companies be used to the same extent in the future as it was throughout COVID-19 lockdowns? Will a systemic event hit travel and leisure business as directly as COVID fears did? And will e-commerce become the sole platform for retail? Honestly, it remains too early to answer these questions accurately. However, investors (to a degree) subconsciously believed that COVID was the start of the inevitable as the environment sped up long-term shifts in industry standards. This basic behavioral nearsightedness is a predictably irrational behavior displayed by the economic problem known as “tragedy of the commons.” Let me clarify, this concept can be partially applied to the current dynamics of the stock market. In summary, “tragedy of the commons” is when we use a resource faster than it replenishes. Well, we know the stock market is not a resource we use and subsequentially replenish. However, the idea that we invested too much too fast in disruptor companies fueled by societal fast-forwarding created a situation where our projections far overshot the developments. So, to a degree, this was the “tragedy of the innovator.” At the same time, even if the disruption is short-lived and the external situation that resulted in a fast-forwarding partially normalizes and reverts, we can expect that a proportion of the users or end-consumers who started using the disturbing company or their products will ultimately stick with it. Measuring this retention rate and tracking demand going forward is crucial in determining if the company has promising long-term growth prospects or was simply able to capitalize off a brief period of favorable circumstances, not capturing “sticky” market share.
Let’s take a step back and look at the psychology of the investor. Humans (including investors) fall victim to predictably irrational behaviors rooted in the likes of expectations, anchoring, and the peculiarities of ownership. These cognitive underpinnings create exaggerations or inaccurate interpretations (categorizations) of available information, creating a situation where cheap stocks become too cheap and expensive stocks become too expensive. In addition, irrational investing is further illustrated as investors continue to pay premiums for stocks they like (i.e., GameStop) and stocks that meet political and societal expectations (i.e., Tesla). As Dan Ariely said, “the pricing of something affects our own expectations about that service or product.” The more expensive something is (in this case, a share of stock), the higher expectations are that it is a good investment, potentially making it even more expensive as sentiment increases (the opposite is true if the price is lower). Suppose this momentum investing behavior isn’t accurate. Then, why do you go to a restaurant and always think that the most expensive dinner on the menu is the de facto best option? This mindset accompanied with external stressors fast-forwarding inevitable industry standards potentially leads to a perfect storm of overvaluation and increases the likelihood of a correction. Therefore, this dynamic has depressed value prices to levels that remain increasingly attractive, leading to value outpacing growth YTD in 2021.
Unfortunately, nothing continues in a linear trend, but regardless if you believe in the efficient market hypothesis or behavioral finance, the patterns yield the same results: “a pullback.”
It is important to note that a pullback is not always bad, and many times it is a healthy situation that propels a bull market. Pullbacks and market sentiment rotations provide investing opportunities. One of these opportunities is value stocks. As many know, value stocks had a poor post-crisis decade with some glimpses of a turnaround (but to no prevail). Though the cloud of doubt regarding if value stocks are experiencing another glimpse of hope remains viable, one crucial point counter to this fear is that value stocks are still cheap and have become increasingly cheap since the Great Financial Crisis, reaching a post-COVID pinnacle. For instance, the spread of the book-to-price multiple between value stocks and the overall market displays the cheapest levels since the data started in the 1950s. This can bode well for the segment’s recovery, especially with inflationary pressures weighing on growth stocks. As we work through the “Great Rotation,” cyclical laggards have become the investing favorite as of late, further driving the value stock recovery. This is evident as February 2021 was the best month for value vs. growth (among large-cap stocks of the US Russell 1000) since March of 2001 (20 years ago).
In conclusion, it is important not to fall victim to over-confidence in value stocks or over-pessimism in growth stocks as the recovery is still relatively small compared to the absolute underperformance value stocks experienced since 2008.
Additionally, it is important to realize that disruptive companies and growth companies are long-term stances for potential value capture and remain a long-term bullish stance towards innovation. Regardless, value stocks look to be at historically cheap levels that could provide some opportunities to help navigate sector rotations. But will value sustain its’ rebound? Though the current environment favors value, this question remains a topic to be monitored in the medium-term as market rotations start to ease.