Value stocks have had a great run, but they are not over-valued.
It is the highish valuations of growth stocks that should worry us more than those of value stocks.
Sometimes markets are efficient and changes in share prices don’t provide a buying or selling opportunity.
I say this because value stocks no longer offer great value. The dividend yield on the FTSE 350 high-yield index (a gauge of value stocks) is now only 2.2 percentage points above that on the FTSE 350 low-yield index. That’s close to the lowest gap since 2007. Which suggests that value stocks are relatively expensive.
This has happened because hopes of an economic recovery have pushed up value stocks a lot. The FTSE 350 high yield index has risen over 30 per cent since last September, causing many shares that were on high yields then – such as airlines and travel stocks – to see those yields plummet.
We know that equities sometimes over-react to good news and rise too far. Has this happened to value stocks?
If history is any guide, no. Since 1990 there has been zero correlation between the valuation gap between value and growth stocks and subsequent annual changes in value stocks or indeed in growth ones. There has therefore also been no correlation between this gap and subsequent returns on the All-Share index. Yes, a low gap has sometimes led to equities falling, such as in 2002-03. But just as often it has led to them rising, such as in the late 1990s or mid-2000s.
The relative valuation of value stocks therefore tells us nothing about where equities are heading.
But there is something that the gap does predict, albeit slightly – economic growth. A low gap has led more often than not to rises in manufacturing output, gilt yields and inflation expectations. Low gaps in 1998 and 2005-06, for example saw the economy do well in the following 12 months.
Which tells us something important. Investors in value stocks often know what they are doing. When value stocks are highly rated, as they are now, it’s often because the economic outlook really is good, and not because investors have got carried away.
The converse is also true. High yields on value stocks can be a sign not that they are a bargain but that they are genuinely riskier because the economic outlook is grim. Yields on value stocks rose in 2007-08, for example, which in hindsight was a warning of big trouble, and not a buy signal.
Of course, investors in value stocks aren’t always right: nobody is. The point is that low yields on them are (slightly) more likely to be a sign of good times to come as a sign that investors have over-reacted. Sometimes, the market is efficient.
I say all this for a reason. Academics and market pundits (and me) tend to talk a lot about evidence for predictability in returns while keeping quiet about evidence of non-predictability. There’s a name for this – publication bias, and it afflicts all disciplines and not just finance. This can have a nasty effect, even when the evidence for predictability is strong (which it sometimes is not). In encouraging us to believe there’s more predictability in equities than there really is, it makes us believe that investing is easy. Which reinforces common errors such as overconfidence and the illusion of knowledge and so emboldens us to take too much risk.
Sometimes, therefore, we need reminding that some things – many things – are not buy or sell signals at all.
That said, there is some predictability here. Yields on growth stocks have helped predict returns. There has been a significant correlation (of 0.56 since 2000) between the yield on the FTSE 350 low yield index and subsequent annual changes in the All-Share index. Low yields on growth stocks in 2000-01 and 2011 led to falls in share generally while higher yields on them in 2004-05 and 2009 led to a rising market.
Growth stocks’ yields predict returns, then, but value stocks’ yields do not. This is common sense. Growth stocks are more sensitive to swings in investor sentiment, and we know that this can rise and fall too far, which leads to predictable returns.
With yields on growth stocks now slightly below their long-term average, this is a reason to be slightly wary of equities in general – a message which corroborates other signals such as the low yield on the All-Share index, a high ratio of global share prices to the money stock, relatively high prices of Aim shares and the fact that it is the wrong time of year for equities. What we shouldn’t worry about, though, is the message from value stocks – because if there is one at all, it is in fact mildly encouraging.
