Investors are wondering whether the bull run in US equities is over. With the economy gathering steam and interest rates likely to head higher, we think stocks are still the best game in town—and value stocks neglected in the recent rally look even better.
What’s backing our confidence? The US Federal Reserve has made monetary tightening contingent upon a well-entrenched economic recovery. We also see corporate profits staying fairly resilient or even improving, as a demand-fueled resurgence in sales growth combines with already lean cost structures. Under such a scenario, we would expect US stocks to reclaim leadership from bonds, even given today’s elevated stock valuations.
That was also the conclusion of our capital-markets forecasting model,1 which considers historical relationships and current conditions to generate thousands of possible market outcomes across assets. It forecasts the median annual return over the next 10 years for a 100% US large-cap stock portfolio at 6.6%, below the historical pace but well above the 2.8% median return for the seven-year US Treasury bond. Even the model’s worst-case scenario for stocks—annual gains of 2.4%—nearly matches the median case for bonds.
The long-term performance advantage we see in stocks is largely a by-product of the market’s postcrisis gorging on safe assets. Allocations to bonds and cash are now well above historical norms. Of course, most investors want and need the relative stability, income and diversification benefits that bonds can provide. But portfolios overladen in bonds may feel less safe as strengthening economic growth puts upward pressure on interest rates. In this setting, the best offset to bond risk may be stocks.
Of note, stocks don’t seem to be pricing in excessive hopes for profits. Our research found that, even after the recent rally, expectations for future earnings growth accounted for only about 15%–20% of the S&P 500 Index’s value, or just about half the 34% average since 1961 (Display). As economic growth picks up, investors are likely to ascribe more value to future earnings, lifting stock prices. And with the Fed linking the path of interest rates to economic vigor, gains in stocks are likely to be accompanied by losses in bonds.
In our analysis, value stocks offer even greater upside potential than stocks generally. The most expensive quintile of US stocks now trades at 10.8 times book value—the highest absolute level since 1965 and four times higher than the S&P 500’s multiple, a record premium. Meanwhile, the cheapest quintile of US stocks sells at 1.2 times book value, a 56% discount to the market and roughly in line with the historical average in absolute and relative terms. By concentrating on the cheapest stocks and avoiding the most expensive ones, investors have a good chance of beating the market over time. Indeed, given the enormity of this valuation gap, we believe that the odds of success for deep-value strategies have rarely been better.
Value stocks are also likely to be more diversifying versus bonds than stocks generally. After years of underperformance, high-beta, cyclically sensitive stocks now dominate the value realm, making it far more sensitive than usual to broad economic trends. Moreover, according to our research, 95% of the returns of low price/book stocks since 1982 have come from multiple expansion (or growth-driven repricing). That compares with 59% for high-dividend-paying stocks. What’s more, in periods of rising interest rates from 1982 through 2012, cheap stocks have beaten the market by an average of 1.6%, on a rolling-three-month basis. That’s twice their average outperformance for the full 30-year period (Display). High-dividend-yielding stocks have trailed the market by 0.6%.
For the past several years, investors’ desire for safety has eclipsed even their desire for higher returns. But, as interest rates begin to normalize, we may be reaching the point at which investors can find the safety they crave where they least expect it—in value stocks.
Joseph G. Paul is Chief Investment Officer of US Value Equities.
This blog was originally published on InstitutionalInvestor.com.
1The AllianceBernstein Capital Markets Engine is a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and rate of inflation, producing a probability distribution of outcomes; however, it goes beyond randomization by taking the prevailing market conditions into consideration and basing the forecasting on the building blocks of asset returns, such as inflation, yield spreads, stock earnings and price multiples. The analysis incorporates the linkages that exist among the returns of the various asset classes and factors in a reasonable degree of randomness and unpredictability. There is no guarantee that the returns presented will actually be realized.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.