After long wait, value investors are ready for a rotation

After a year of historic divergence within equities markets, some investors are hoping that a Covid-19 vaccine will turn the tables on growth and value stocks.

Growth stocks have outperformed value stocks by more than in any previous year, according to Richardson GMP’s analysis of the S&P 500, owing to changing behaviour such as working from home as well as other market factors such as future cash flow.

“With yields falling due to the recession/pandemic, the discount rate on these future earnings is less, making them worth more,” a Richardon GMP report says of growth’s advantage.

The effect can be seen in markets such as Canada and Europe, where equities have a higher value tilt. Canadian and European equities are down 2% and 8% for the year, respectively, while the S&P 500 is up 10%.

“It is fair to say that this has been a perfect storm for growth at the expense of value,” Richardson GMP says.

That may have started to change last week after Pfizer released preliminary data demonstrating the effectiveness of its vaccine. The news raised hopes for beaten-down sectors such as airlines, energy and financials that the economy would return to normal faster than previously expected. For the week, the S&P 500 Growth index was flat while the S&P 500 Value index was up 5.6%, according to Richardson GMP.

On Monday, rival vaccine maker Moderna also released strong data from preliminary testing of its vaccine.

The vaccine news has led market analysts to speculate about whether a rotation from growth to value is underway, as some investors look to exit pricey tech stocks with big profits.

A BMO Economics report described a “violent rotation” to value last week, which benefited European stocks, U.S. banks and industrials.

“Some of [last] week’s moves might prove to be temporary reactions, while some might foretell where relative strength will be found when the end of the pandemic really does come into view,” the BMO report states.

A rotation from growth to value, if it is underway, could last a long time, Richardson GMP says. Growth stocks are trading at 27 times their price to earnings based on forward estimates, compared to 17 times for value stocks.

The 10-multiple-points difference is “extreme,” the report states. “If this reverted to the more historical norm of five multiple points, that implies a 19% decline in growth or 29% rise in value (or a less dramatic combination of both).”

Richardson GMP also notes that growth stocks tend to outperform during periods of negative economic growth while value does well when overall earnings are strong. Consensus estimates for the S&P 500 next year call for a 40% earnings growth rate.

While one week doesn’t make a trend, Richardson GMP recommends investors take profits and redeploy into value, while not abandoning growth stocks entirely. Rising infection rates and delayed government stimulus could still boost growth stocks, but the authors are confident that the trend will turn.

“The equity market, which is really an aggregate of everyone’s future expectations, will likely start favouring value over growth long before any of us stick a needle in our arms,” the report says.