Technology stocks like Apple are under pressure as higher interest rates sends investors back to “value stocks.”
In a replay of moves earlier in the coronavirus rebound, financials, energy and transportation companies are jumping. Technology, communications, health-care and income stocks are falling.
The change represents a flip between two fundamental approaches to the market. The “stay-at-home,” or pandemic perspective, focuses on growth companies with new and disruptive technologies that benefit from the lockdowns. They often trade at higher multiples, which makes them more attractive when interest rates are low. Other companies that benefit from low interest rates or tepid economic growth can fall under this umbrella. That would include health-care, consumer staples, utilities and real-estate.
The “reopening” perspective is almost the polar opposite. It looks for the economy to surge as businesses recover. That entails more travel, more jobs, higher interest rates and sharper inflation. “Value” stocks tend to perform better in that environment because they benefit more from a strong economy. Below are more key things to know about value stocks.
Value Stocks Are ‘Cheaper’
True to their name, value stocks trade at lower valuations relative to fundamentals like earnings, revenue or book value.
For example, the iShares Russell 1000 Value ETF (IWD) has an average price/earnings ratio of 25 times. For the iShares Russell 1000 Growth ETF (IWF), that measure is 47 times.
Many “growth” industries like software and Internet stocks also trade for at least 8-10 times revenue. Value industries like industrials and financials often trade for less than 2 times revenue.
Price/book value compares a company’s market capitalization to its underlying value, or assets minus liabilities. Technology stocks often trade for more than 5 times book value, while some financials and energy companies trade for less than book value.
Higher Rates Often Help Value Stocks
Lower valuations can help when interest rates rise because investors use methods like discounted cash flow or the “Fed model” to assess an investment’s price.
To understand this, flip the traditional price / earnings ratio of a stock upside down. You can also analyze a company based on earnings / price, or “earnings yield.” A $20 stock with annual per-share earnings of $1 has a P/E multiple of 20-to-1 and an earnings yield of 5 percent.
When interest rates rise, its yield must compete with other rates in the market. That means its yield must rise, and therefore its price must fall.
Financials Are ‘Value Stocks’
Financial stocks like banks are the biggest industry within the value universe. There are several reasons why they perform well at times of economic strength.
First, banks make money from faster growth as businesses borrow to expand.
Second is the “steeper yield curve.” Banks borrow at short-term rates and lend at longer-term rates. They make more money when the two diverge, or the spread (difference) steepens.
Third, banks benefit from a stronger economy because fewer borrowers default on their loans. Data from S&P/Experian shows that defaults on mortgages and auto loans in July fell to their lowest since at least 2007.
Industrials Are ‘Value Stocks’
Industrial stocks are another major category within the “value” bucket. These are mostly manufacturing companies like Honeywell (HON) and Boeing (BA), but the group also includes transportation companies and providers of business services (like rentals and staffing).
Industrial stocks benefit from a strong economy, which increases demand for manufactured goods and transportation services.
Energy Stocks and Inflation
Traditional fossil-fuel companies like Exxon Mobil (XOM) have also fallen into the value indexes after years of underperformance. They’ve also lost favor as investors shift toward alternative energy and “ESG” stocks like solar and electric vehicles. As a result, many traditional oil-and-gas stocks trade for less than 2 times book value.
This may create opportunities for investors because energy demand is rebounding as the economy reopens. Meanwhile, production is still lagging.
There are also concerns about rising inflation, which is pushing the Fed to tighten monetary policy. Because they own one of the most important commodities whose price is increasing, some investors may view energy stocks as a hedge against rising inflation.
The Fed and Value Stocks
Finally, Federal Reserve said last week it will reduce monthly asset purchases “soon.” That’s a potential first step toward raising interest rates, which half of policymakers support doing next year.
Officials have only added to the hawkish message since then.
“We have made substantial further progress on achieving our inflation goal,” New York Vice Chair John Williams said yesterday. That implies he’s less willing to keep interest rates low. Chairman Jerome Powell added in Congressional testimony that inflationary pressures “have been larger and longer lasting than anticipated.” He also said policymakers would “certainly respond” if price increases become a “serious concern.”
In conclusion, the market has gone through several phases of value outperformance as it recovers from the coronavirus pandemic. The first rotation occurred in November after the vaccine news spurred confidence in the reopening. The next occurred in March as oil prices reclaimed their pre-pandemic levels. A final push ended in early May before investors rushed back to the Nasdaq-100. Now with interest rates and energy prices rising again and coronavirus infections declining, the same pattern may be returning again.