Uncommon Sense

Everywhere I Go, People Want to Know… Will These 3 Equity Relationships Ever Mean Revert?

"Reversion to the mean is the iron rule of the financial markets."

— John C. Bogle

Michael Arone, CFA
Chief Investment Strategist, State Street Global Advisors

One of the great things about my role is that I have the opportunity to spend a lot of time with clients throughout the United States. And these days, we have plenty to discuss. The coronavirus outbreak is likely to result in slower global growth and falling corporate profits over the next couple of quarters. Meanwhile, Bernie Sanders is surging in the national polls. Bernie’s bid to top the Democratic ticket in November is raising investors’ worst fears. Mainly, that their treasured business-friendly environment of lower taxes and less burdensome regulations will be snatched from them next year under a progressive Democratic policy agenda.

So far, markets have mostly taken these budding risks in stride. The S&P 500 Index has reached a dozen record highs already this year. Most market watchers expect the negative impacts of the coronavirus to be temporary. Many of those same folks are forecasting a gigantic recovery in the second half of this year to make up for any coronavirus-induced shortfalls during the first six months of 2020. And, despite Sanders’ celebrity, few market participants give the self-described Democratic Socialist much of a chance to dethrone President Trump come November.

Meanwhile, US economic data continues to signal an economy that keeps chugging along. The fourth-quarter earnings season just wrapped up, and results were much better than expected. Finally, the Federal Reserve and other global central banks, most notably the People’s Bank of China, remain firmly committed to keeping markets afloat.

So, what’s not to like about stocks?

Rules Were Meant to Be Broken
Like me, many clients have a strong appreciation for value investing and an unwavering faith in the power of mean reversion. But our collective faith has been shaken during the past decade. Today, alarmingly, several long-established equity relationships have breached extreme levels. As a result, the most common equity questions I get from clients these days are:

  1. Will US small-cap stocks outperform large-cap stocks?
  2. When will value stocks finally beat growth stocks?
  3. Is investing in international developed and emerging markets dead?

For the relative value and mean reversion faithful, US small caps, value stocks, international developed and emerging markets equities are tempting. However, it’s difficult to identify a near-term catalyst for a rebound in their performance. Perhaps I’m dangerously extrapolating the dominant trends of the past decade — US, large-cap, and growth stocks crushing virtually all other investment choices. But like so many relationships in the post-global financial crisis era, small-cap, value and non-US investing seem to have been forever changed by the extraordinary interference of governments and central banks in financial markets.

So, while investors may experience some periods of outperformance from their small-cap, value and non-US investments, it is likely to be short-lived. Without a meaningful shift in economic growth rates, inflation expectations and real interest rates, the dominance of US large-cap growth stocks is poised to continue for a while longer.

Now let’s further examine just how out of whack these equity relationships have become over the past decade.

David Versus Goliath
The most popular US small-cap benchmark, the Russell 2000 Index, hasn’t bested the S&P 500 Index since 2016. In fact, in the past 10 calendar years, small caps have outpaced large caps only four times. Three of those victories occurred during the 2010 to 2013 period, meaning that David has beaten Goliath just once in the last six calendar years. Not surprisingly, investors have voted with their feet. Through February 21, US large-cap ETFs had $19.1 billion in inflows, while US small-cap ETFs suffered $2.1 billion in outflows. Over the past 12 months, US large-cap ETFs have taken in a staggering 17 times more money than US small-cap ETFs.

According to US small-cap guru Steven DeSanctis from Jefferies Group LLC, the five largest stocks in the Russell 1000 Index are now 2.3 times the size of the entire Russell 2000 Index. DeSanctis describes the move as “parabolic.” What’s more, the price-to-sales ratio for the largest five stocks is at its highest level since 2003 and, relative to the Russell 2000 Index, is 103% above its average.

It’s easy to see why these extreme differences between US large and small caps have stoked the curiosity of the mean reversion crowd. However, it may be too early to make the jump into small-cap stocks. At the end of the day, it’s about earnings, and small caps simply don’t have them. About one-third of the Russell 2000 stocks don’t make a profit. Small-cap earnings-per-share fell sharply in 2019, while large caps were able to squeak out a modest gain. US small-cap earnings have trailed large-cap earnings for 12 of the past 13 quarters. This earnings dynamic needs to change before US small caps can retake leadership from large caps.

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Source: FactSet, 02/19/2020. Past performance is not a guarantee of future results.

The Tortoise Versus the Hare
Growth, growth, baby! The past decade has been dominated by growth stocks. The Russell 1000 Value Index has surpassed the Russell 1000 Growth Index only three times in the past 10 calendar years. Moreover, the magnitude of growth’s outperformance over the decade is shocking. On an annualized basis over the past three years, growth has trounced value by more than 10%. Value last outshined growth in 2016 when, in the aftermath of Trump’s surprise election win, previously beaten-down value sectors like energy and financials rallied briefly. However, that didn’t last long as growth stocks demolished value stocks by more than 16% the following year.

Over the past 12 months through February 21, growth ETFs have had respectable inflows of $14.3 billion. Remarkably, despite value’s sizable underperformance relative to growth, value ETFs had even greater flows of $17 billion. However, there may be signs that value investors are finally throwing in the towel. So far this year, growth ETFs have gathered $5.8 billion in inflows, while value ETFs have endured $1.4 billion of outflows.

While hope for value’s return springs eternal, it's likely premature to dump growth stocks for value stocks. With the coronavirus epidemic has dashing all those hopes for a rebound in global economic growth, marginally higher interest rates and rising inflation in 2020, the backdrop for value investing remains unfavorable. Further, 10-year Treasury yields have plummeted to 1.37% to reflect a much slower global growth and inflation environment.

When organic revenue growth is scarce, as it is today, investors are willing to pay a premium for companies that demonstrate high rates of top-line growth. According to Empirical Research Partners, technology companies generate twice the amount of revenue per employee compared to the broader market and four times the profit per employee. What’s more, when the cost of capital is essentially zero, high-flying growth companies with no profits and weak business models can become huge. Without a meaningful pickup in growth, inflation and interest rate expectations, it’s difficult to envision a path for value stocks’ outperformance. Growth stocks are likely to continue their dominance over value stocks for the remainder of the year.

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Source: FactSet, 02/19/2020. Relative valuations are based on combined percentile ranking of P/E, Forward P/E, P/B and P/S.

US Versus Everybody
At least when it comes to stock market performance, American exceptionalism is thriving. The MSCI EAFE Index has lagged the S&P 500 Index in eight of the last 10 calendar years. The MSCI Emerging Markets Index performed marginally better, topping the S&P 500 three times in the past decade. Both the EAFE and Emerging Markets indexes exceeded the S&P 500 return in 2017, but you have to go back to 2012 to find another year when either of the two popular non-US benchmarks beat the S&P 500.

The relentless underperformance of international developed and emerging markets stocks has some relative value investors and mean reversion devotees licking their chops. International Developed ETFs attracted $12.4 billion in inflows through February 21 and $42.5 billion over the last 12 months. Emerging market ETFs have joined in the fun, too -- adding $3.2 billion through February 21. However, those flows are still no match for US equity ETFs’ dominance. US Equity ETFs added $30.2 billion through February 21 and a whopping $186.9 billion in the last 12 months.

After the US-China Phase One and USMCA trade agreements, reaccelerating non-US growth and a weaker US dollar (USD) were supposed to be catalysts for those international developed and emerging markets investments. However the coronavirus outbreak has thrown an unexpected monkey wrench into that logic. Growth expectations have been plunging, and the USD recently hit its highest level since May 2017. Without an improvement in growth outside the US and a softer dollar, it’s unlikely that international developed and emerging market equities will soar anytime soon. Despite the powerful forces of relative value and mean reversion on the side of non-US equity investments, US exceptionalism is likely to continue to trump most non-US markets in 2020.

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Source: Bloomberg Finance, L.P., 02/19/2020

Fighting Temptation
None of this is meant to undermine the importance of a diversified portfolio. A well-diversified investment portfolio should include investments in US, international developed and emerging markets. It should also have exposure to large, mid and small-cap stocks. And throw in some growth and value stocks for good measure, too.

However, US small caps, value stocks, and international developed and emerging market equities have routinely underperformed their counterparts over much of the past decade. Anticipating that something has to give, relative value and mean reversion followers are eager to put money to work in these unloved investments. I acknowledge that I may be falling victim to the behavioral bias of extrapolating recent trends, but slow growth outside the US as well as low real interest rates and inflation expectations continue to present headwinds to the mean reversion thesis. The coronavirus makes it even more difficult to envision a significant change in market trends.

Value investors and mean reversion enthusiasts looking for someone or something to blame should look no further than the incredible market distortions brought on by extraordinary government policies and unprecedented central bank interference in financial markets. I don’t know about you, but I don’t see that changing anytime soon. As a result, I expect that US large-cap growth stocks will soldier on for a little while longer.


Earnings per share (EPS) Calculated as a company's profit divided by the outstanding shares of its common stock. The resulting number serves as an indicator of a company's profitability.

Gross Domestic Product (GDP) The total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of the country’s economic health.

MSCI EAFE Index A stock market index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada.

MSCI Emerging Markets Index Captures large- and mid-cap representation across 26 emerging markets countries.

Russell 1000 Growth Index refers to a composite that includes large and mid-cap companies located in the United States that also exhibit a growth probability.

Russell 1000 Value Index A composite of large and mid-cap companies located in the United States that also exhibit a value probability.

Russell 2000 Index A small-cap stock market index of the smallest 2,000 stocks in the Russell 3000 Index.

S&P 500® Index A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.


The views expressed in this material are the views of Michael Arone through the period ended February 21, 2020 and are subject to change based on market and other conditions. This document contains certain statements that
may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

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Exp. Date: 02/28/2021