This article first appeared in the AFR on the 20 July 2020
Going underweight or short Japanese government bonds in the past two decades has often been referred to as the widowmaker trade, as it was the bet that never paid off.
There’s a similar trade in equity markets these days: owning unloved value stocks. Aside from relatively brief diversions into value names, market leadership has remained with growth, especially technology names. What is going on?
Actually, the two widowmaker trades reflect the same phenomenon, just with a decade or so lag. Other developed markets have undergone Japanification. That is, they are following a similar path of slowing demographics, lower demand and lower growth.
This in turn has resulted in lower interest rates. Given these longer-term or structural drivers of lower interest rates, bond prices have followed a one-way upwards path, just as they did in Japan.
As well as driving bond prices higher, lower interest rates have also boosted the valuations of growth stocks, relative to other stocks. There are two reasons for this.
Lower interest rates signal weaker future overall economic growth, making secular growth stocks more sought after. And lower rates also feed into valuation calculations.
If a stock trades on 20 times earnings when the risk-free rate is 3 per cent, that same earnings stream should be valued on 30 times if the risk-free rate falls to 1.5 per cent, a 50 per cent uplift in valuation.
If the risk-free rate falls all the way to 0.5 per cent then the appropriate multiple is more than 40 times. In this case, if the earnings forecasts remain intact as rates fall, the value of the company more than doubles.
But stocks with less robust cashflow trajectories experience a much smaller percentage increase in their derived valuation as discount rates fall.
This goes partway to unlocking the conundrum of the rapid rebound in global stock markets over the past quarter. After experiencing one of the steepest declines in history, markets then rebounded, with the S&P 500 experiencing its best performance in 20 years.
How can this make sense when underlying economic conditions are easily the worst of the post-war period? In previous periods of economic turmoil markets have typically tracked lower with the economic aggregates, then found a bottom and rebounded, with value stocks becoming the new leaders of the nascent bull market.
Why have markets in 2020 taken a different path?
Thanks to the truly unprecedented size and magnitude of central bank interventions, markets quickly jumped to the conclusion that the longer-term interest rates that are the reference rate for long-duration assets like equities must fall and must stay low for a very long time.
So we are left with an investment equation of drastic falls in economic fundamentals, which then decompose into the earnings of secular growth stocks (which are unscathed or perhaps even enhanced), and the earnings of all other stocks (which fall somewhere on a spectrum of unforecastable to disrupted, to abysmal).
Then the impact of aggressive policy interventions results in higher multiples (lower discount rates). When these are applied to the earnings streams of growth stocks, the overall valuation goes up versus what was justified in 2019, as a higher PE multiple is applied to stable or larger earnings.
For the other stocks, their recovery or look-through valuation is more likely to be lower or at best unchanged, as higher multiples are applied to lower future earnings.
In other words, as far as equity markets are concerned, policy interventions have done their job, and have offset the economic damage. After a terrible train crash, all the passengers were rushed to the emergency room and everyone was given large and rapid blood transfusions.
Many of the injured are now up and walking around again — but the ones who weren’t hurt now feel better than ever!
So not only is there no bear market, but there’s also no change of market leadership. With the valuation impact of rising PEs offsetting the impact of earnings movements, the playbook has changed. Rather than being toppled from their lofty heights, growth stocks are continuing to climb, leaving value stocks in their wake. And value investors are left yet again with a widowmaker trade.
Perhaps we are now entering the final blow-off of growth, and value is set for an almighty reversionary leg upwards. Or perhaps, as traders of Japanese bonds learned to their peril, central bankers can stay accommodative longer than contrarians can stay solvent.
