Charting the Market: Where are there value opportunities?

Even with the slight stumble in late January, global equity markets are still less than 1% away from their all-time highs.¹ With markets elevated, broad-based valuations are also stretched – most notably in the US. This has brought on more frequent “is this a bubble?” discussions, evidenced by Google Trends search ranking for the words “stock market bubble” recently hitting 100² and a news headline scan for the same words also registering highs not seen since January 2018. Back then, the S&P 500 had spent 16 consecutive days over an RSI of 75 – the longest stretch ever – and hit a record RSI of 86.69.³

Setting aside the bubble talk, as market prognosticators have called five out of the last two bubbles, the stretched valuations are leading investors to wonder where there may be “value” right now.

Here, we analyze various metrics to uncover potential value opportunities – important right now, as cyclical, more value-oriented segments may have stronger relative performance than the broader market as the global economy recovers.

Dissecting global value opportunities
The weak performance of value strategies over the past decade encourages the “who cares” where there is value argument. As shown below, whether it is mega, large, mid, small, or foreign, value has spent most of the 2010s underperforming a “growth” led market. With performance like this, it is fair to say that value could have given an aspirin the headache of its life in the last decade. Yet, if there wasn’t interim pain, then there wouldn’t be a long-term premium. And one could argue that this dour performance has pushed the marginal buyer out, leading to the value premium being noticeably inexpensive as the 2020s began.⁴

To understand global value opportunities at the regional level, we utilize a composite approach of four different valuation metrics. Composite approaches help mitigate biases in one specific metric, a topic discussed in the blog on performing valuation analysis on innovative exposures. The metrics are analyzed both relative to their own 15-year history and relative to the S&P 500 Index over the past 15 years, bucketed into percentile ranks (with 100% being expensive and 0% being cheap). The table below lists the major regional and style exposures percentile ranks and the associated composite z-score of the current ranks. As shown, there are no negative composite z-scores (indicating all regions are stretched relative to their history), and not one of the metrics is below the 75% percentile.

When we break this down by major countries, we get the same result. However, some of the individual metrics fall below the 50%-tile mark.

Examining this on a relative basis to broad US large cap, however, shows where there may be relative opportunities. From a regional perspective, Europe screens the cheapest, with US value and US small cap also screening as potentially attractive. The metrics for small cap indicate why a composite approach is desirable, as based on the price-to-to-earnings ratio small caps trade in the 95^th percentile. Yet, this is a function of poor trailing 12-month earnings from the pandemic. The other metrics are all in the bottom decile.

At this level, it’s clear that value, small cap, and Europe are the most attractive relative value options. And for US small cap, these constructive valuations are being met with increasing positive earnings sentiment, evidenced by climbing 2021 upgrade-to-downgrade ratios and expected 60% growth in full-year 2021.⁵ Emerging markets (EM) is approaching a neutral level based on the z-score above, driven by the upward move in valuations from China – where all metrics trade at the 50 percentile. Given China’s expected growth and the potential for more cooperative trade relations with the US under the Biden administration, these valuations are still constructive.

Dissecting US sector value opportunities
Broad-based valuations are stretched, there is no denying that. But perhaps they are stretched because bond rates are so low, which continues to perpetuate the There is No Alternative (TINA) theory of investing. Comparing the earnings yield on stocks to the US Treasury 10-year Yield is one way to showcase the relative valuations of stocks to bonds. An earnings yield equivalent to the US 10-year yield would indicate stocks could be expensive, as the cash flows passed through by stocks in terms of earnings are no different than the rate you receive on less volatile bonds – leading to greater preference for bonds, all else equal.

In the chart below, the higher percentile rank indicates lower earnings yield premium and more expensive valuations. As shown, the earnings yield premium for some sectors and growth stocks rank above the 50 percentile, indicating slightly more expensive valuations relative to the past 15 years. Yet, small caps once again screen attractive. From a sector perspective, however, Financials is the most attractive.

More data indicate the potential value opportunity in Financials, and that these metrics are not a value trap. In our monthly sector scorecard, we perform a quantitative analysis for valuation (using the same process for the regions and styles), momentum, and earning sentiment. Financials ranks in the top three across all metrics. The positive earnings sentiment is reinforced by 2021 earnings-per-share estimates increasing by 7 percentage points, following financial firms beating earnings by 29 percentage points in Q4 2020⁶ – only energy stocks had better rates on both, given the easy comparables that sector has from vastly negative figures and estimates.

Unlike Energy, however, the Financials sector has not seen forward price-to-earnings ratios expand over the past year. In fact, Financials is the only cyclical sector, as shown below, that has not seen that much multiple expansion based on expected earnings for the next two years, indicating stronger value prospects looking ahead as recent price increase have been met with equivalent earnings increases – with one not getting ahead of the other.

Value hunting in 2021
With broad valuations stretched, the data above portends more attractive value opportunities in US Financials and US small caps, as well as overseas equities – in particular, Europe and EM. And in our 2021 Outlook we provide the macro case for Financials to complement the fundamental tailwinds discussed in this post.

The global equity markets will continue to evolve as our society seeks to navigate a once-in-a-lifetime recovery following a once-in-a-lifetime crisis. Continue following our SPDR Chart Pack to see how valuations and these value opportunities evolve along with it.