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Summary It’s been a rough ride for value investors, but there is reason for optimism. Value stocks have been laggards of late, but economic conditions could reverse this trend. Investors looking to increase their exposure to value shares may want to consider making a move now, before interest rates rise and investors drive up value share prices. By: Nick Kalivas, Senior Equity Product Strategist Value stocks have been laggards of late, but economic conditions could reverse this trend Like a presidential candidate with no populist appeal, value stocks have had a tough time of it in 2015. Through September, value shares, as measured by the Russell 1000 Value Index, are lagging the S&P 500 Index by 3.67% and trailing the Russell 1000 Growth Index by more than 7%. Value stocks tend to be found in financial and other cyclical sectors. Financials and utilities sectors have fared the worst thus far in 2015, while less-defensive consumer discretionary sector shares have performed somewhat better. Investors tend to embrace value stocks because they believe the shares are trading inexpensively relative to a company’s intrinsic value; the belief is this disconnect will eventually lead to excess returns as market participants recognize a stock’s value and drive up its price. In theory, a stock’s ability to undergo “mean reversion,” or a move toward its intrinsic value, shouldn’t be affected by cyclical economic swings. But this often happens, nonetheless. Reasons for value stocks’ underperformance in 2015 Why have value shares continued to struggle even in light of an improving economy? Interest rates. Value stocks tend to find favor when interest rates are rising. This makes sense when you consider that rates often rise behind strong economic growth, which typically benefit cyclical sectors like energy, industrials and financials. We have been in a zero interest rate environment since 2008, but given the correlation between value shares and interest rates, it would stand to reason that value shares could benefit should the Federal Reserve decided to take a less accommodative approach to monetary policy. Industrial production. The performance of value stocks has traditionally shown strong correlation to industrial output. The chart below shows the ratio of the Russell 1000 Value Index to the Russell 1000 Growth Index relative to US industrial production. Source: Bloomberg L.P., Sept. 30, 2015 Here you can see that value lagged into 1990, 2000 and 2008. These periods all have a common denominator in that they were marked by recession. The relationship between value and industrial output isn’t perfect. Sometimes it is muted with a lead or a lag, but the historical weakness of value stocks around contracting industrial production is clear. While the U.S. economy has technically been out of recession for more than six years, industrial production has been hindered by a strong dollar, weak growth in emerging markets and high inventory levels. Inventory overhang. Inventory is closely related to industrial production. In fact, the inventory-to-sales ratio has historically been a predictor of industrial production growth. Firms with excess inventories will typically try and clear out this overhang before making investments to replenish it. As depicted in the chart below, US inventories are at their highest level in nearly five years, but the inventory-to-sales growth rate has recently shown signs of cresting. This should eventually bode well for capital spending levels. Source: Bloomberg L.P., Sept. 31, 2015 Economic conditions look to favor value shares It’s been a rough ride for value investors, but there is reason for optimism. Within the consumer discretionary sector, analysts surveyed by Bloomberg are expecting strong third-quarter earnings growth from retailers and automakers to the tune of 14.0% and 30.2%, respectively, while the real estate industry is expected to provide a boost to financial stocks. And while the Federal Reserve passed on hiking interest rates during the last meeting of the Federal Open Markets Committee (FOMC), the FOMC reiterated the need to hike rates when it sees further improvement in the labor market. Over time, a strong economy tends to see higher rates and benefits defensive sectors like financials and deep cyclicals. As for industrial production, there is hope that it, too, will increase, as the lagged impact of a higher dollar wanes and the growth rate of the inventory-to-sales ratio shows signs of peaking. Lower inventories should lead to increased production, and value shares will likely perform better when industrial output growth moves higher, in my view. Investors looking to increase their exposure to value shares may want to consider making a move now, before interest rates rise and investors drive up value share prices. Of course, talk with your financial adviser about your situation before making any investment decisions. The PowerShares Dynamic Large Cap Value Portfolio (NYSEARCA: PWV ) tracks the Dynamic Large Cap Value IntellidexSM Index, which focuses on large- and mid-cap value companies, while the PowerShares BuyBack Achievers PortfolioTM (NYSEARCA: PKW ) holds securities issued by companies that have shown a propensity to buy back shares – a value-oriented strategy by its very nature. In addition, the PowerShares FTSE RAFI US 1000 Portfolio (NYSEARCA: PRF ) provides access to value-oriented companies. See here for important information and disclosures. Scalper1 News
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