Third quarter observation
The benefits of value investing have been well documented in financial literature. Research has shown that over the long run, stocks with cheaper valuations have outperformed those that are more expensive. However, while valuation factors typically offer a positive return over full market cycles, there have been limited extended periods in which valuation factors underperformed, the current market environment included. In fact, the underperformance of value investing over the last ten years is comparable only to the 1990s tech bubble (chart 1).
What makes the current market environment even more extraordinary is the degree of leadership by the most expensive segment of the U.S. stock market. When dissecting the year-to-date performance of the Russell 1000® and Russell 2000® universes based on deciles of valuation, we found that the most expensive decile of companies have by and large been the best-performing segment of the U.S. market. Within the U.S. large-cap market specifically, the most expensive ten percent of stocks have outperformed the cap-weighted benchmark by more than 23% this year, while all other deciles have been flat-to-negative (chart 2). We see a similar pattern within U.S. small-cap. Although value has underperformed in the past, the extreme nature of outperformance by only the most expensive segment of the U.S. market is unusual, and likely unsustainable.
From a value investor’s standpoint, it is important to focus on the long-term and resist the temptation to believe that “this time is different.” It is also important to have conviction in your process to help participate in recoveries when cycles eventually reverse course. Our research shows companies that have strong fundamental characteristics with attractive valuations and positive investor sentiment tend to outperform over the long-run, and have positioned our clients’ portfolios to help extract excess returns from potential mispricings in the market.
Third quarter overview
Global equities finished the third quarter in positive territory, with U.S. equities leading the charge behind a 7.7% gain in the S&P 500®. U.S. stock returns were driven mostly by continued strength in corporate earnings, backed by growing cash flows and expanding margins. Within the U.S., health care led the rally with a 14% gain, followed by industrials and technology. Conversely, materials, energy and real estate lagged, finishing the period with modest losses.
Momentum factors continued their strong year, after recovering from a brief reversal in June. With many consistent themes driving market returns over the last 12 months (i.e. beta, quality, growth), previous winners continued to outpace previous losers, resulting in strong returns for momentum.
Quality in favor
As tensions mounted over a strong dollar and the potential impact from trade wars, investors preferred higher-quality companies with greater profitability. Longer term, quality factors have been some of the best performers in the U.S. market.
Growth vs. value
After weakness in July, growth factors recovered in August, ending yet another quarter in positive territory. While performance of growth in the large-cap universe was less positive compared to previous quarters, value continued to struggle mightily, marking an exceptionally difficult 12-month period.
The S&P 500® Index is a capitalization-weighted index of 500 large-cap U.S. stocks.
The Russell 1000® Index is an index of approximately 1,000 of the largest companies in the U.S. equity market.
The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe.
Investments cannot be made in an index.