Having posted 58 new all-time highs so far in 2021, global equities are on pace to register their third consecutive year of double-digit returns — a startling run given it has occurred throughout a pandemic.1 Unlike in past years, strong earnings-per-share (EPS) growth has fueled these gains. The 50% projected earnings growth rate for global equities in 2021 is the highest since 2010.2 And in the US, S&P 500 firms posted a record-setting three consecutive quarters of 30% or greater growth on their way to likely registering a decade-best 44% growth rate for 2021.3
With forecasts still projected to be above the 15-year average,4 earnings likely will remain a tailwind for US stocks in 2022, even if they do not reach 2021’s double-digit peaks. Yet, as the new year progresses, sentiment and growth sustainability may become a bigger focus in earnings reports.
Firms may no longer surprise to the upside at 2021’s record rates (over 80%),5 without easy comparisons and the COVID-19 wild card having resulted in disparate analyst estimates to start 2021. In fact, as the cycle matures, monetary policy slowly normalizes in parts of the world, and partisan conflicts heat up, both with the kickoff of the US midterm election cycle and the possibility that the UK invokes Article 16 and reignites the Brexit battle,6 equities may need to adjust to a higher macro volatility regime that could impair sentiment.
However, buying growth in light of lower growth forecasts is not the answer. Broad-based valuations remain elevated, and growth stocks are overly extended and likely to face headwinds from a variety of sources. Therefore, blending quality and value may allow investors to better navigate this peak-growth terrain.
Forecasts for 2021 global economic growth are projected to peak at 5.9%, with expectations for 2022 and 2023 to fall to 4.9% and 3.6%, respectively.7 While those rates are lower than the figures for 2021, they are still above the average growth rate for the past fifteen years.8
From a relative growth perspective, US stocks trailed the rest of the world in 2021 (44% versus 59%). But in 2022, US stocks are projected to grow their bottom line by 8.04% (above their 15-year average) compared to just 5.80% for non-US equities (below their 15-year average).9
The global figures are being dragged down by weak sentiment in emerging markets (EM) where low vaccination rates present reopening challenges in some nations. As a result, EM stocks have witnessed nearly the same amount of upside revisions to downside for their 2022 estimates (1.1), as shown in the following chart.10 EM stocks also have the worst recent one-month change to their forecasts — declining by 24 basis points in October, following September’s nearly 2% decline.11
2022 EPS Upside-to-Downgrade Revisions
Developed international equities have a 1.7 upside-to-downside revision, while US equities have a 2.4 ratio.12 The US also has the upper hand in terms of the changes in its forecasts; developed international forecasts were lowered in September before rebounding slightly in October, while the US has held steady with no declines, only lesser increases.13
For those reasons, the US is our preferred region, followed by developed international. Meanwhile emerging markets remain a challenge, given the weak earnings sentiment, uneven COVID responses, and lingering questions on the Chinese economy (33% of a broad EM exposure).14 China’s ”credit impulse,” a measure of new lending as proportion of GDP and a gauge of economic activity, has yet to trough — falling for nine consecutive months.15 When the impulse reading is negative, Chinese stocks have returned 5% less, on average, over the subsequent six months than when the impulse is positive — with negative returns occurring nearly half of the time.16
With growth transitioning to a simmer from a boil, there has been a greater emphasis on firms with higher quality balance sheets and reliable profitability. This differs from the behavior in the early part of the recovery.
During the first part of the pandemic rally, profitability was less of a concern. From May 2020 to May 2021, US stocks with negative earnings over the prior 12 months outperformed firms with positive earnings by 34%.17 Since May 2021, that performance trend has flipped. Unprofitable firms have trailed profitable ones by 7%.18 Unfortunately, that trend has not forced more firms to become profitable, as there are now over 1,100 firms with negative trailing 12-month EPS compared to 843 before the pandemic.19 As growth slows, this is unlikely to drastically change — at least not in the near term.
Profitability, however, is different than growth. A firm can have a 40% year-over-year growth rate but still be unprofitable, as its EPS could have improved only from -$0.75 to -$0.45 per share. The ability to generate a profit is just one consideration of the quality factor, however. The other is centered on the reliability of growth. Or rather, the volatility of earnings. And pure high-quality stocks have started to noticeably outperform low quality stocks, as shown in the following chart. Yet, the relative performance ratio has yet to re-test pre-pandemic levels and just recently broke through its 50-moving day average — indicating there still may be more room to run even though high quality has outperformed low quality by 6.5% over the past three months.20
High Quality to Low Quality US Equity Performance
With their recent runup, the valuations of traditional quality stocks have started to look a bit frothy like traditional growth stocks and the broader market. In an apples-to-apples comparison, firms within the MSCI USA Quality Index are trading in the 97th percentile relative to their own history, based on a composite metric of valuation indicators.21 And on a relative basis to the MSCI USA Index, they are in the 71st percentile — not overly rich but not cheap either. Quality now appears to come at a price, and it is not alone.
Under the same analysis, growth stock valuations are also stretched on an absolute basis and relative to the broader market. For the latter, growth stocks are trading in the relative 97th percentile and 1.8 standard deviations rich to the market.22 These valuations are ever so slightly shy of dot-com extremes. The numbers are worse when comparing growth to value. As shown in the following chart, growth is trading rich to value by over 2 standard deviations when using the same z-score process for the composite valuation metrics. This is consistent across the cap spectrum, as the premium difference of growth-to-value fundamental ratios is in the average 90th and 80th percentiles for mid- and small-cap stocks, respectively.23
Z-Score of Growth Minus Value Valuation Metrics
One explanation for value trading at cheaper valuations than growth could be that investors are seeking more of a discount given the lower expected future growth. However, 2022 EPS growth forecasts show that the differential of growth projections for the next year between the two styles is quite similar, with value slightly higher at 10.0% versus 9.5% for a composite of value and growth styles throughout the cap spectrum.24 In fact, small-cap value stocks have the highest 2022 growth projections (16%) of any of the six style market segments.25 Value may now be a better growth option given the price to access it.
Beyond the fundamental case made above, there are macro reasons to favor value as opposed to growth. Over the past 30 years, growth stocks’ monthly excess returns to the broader market have a negative correlation to changes in interest rates (-17%), whereas value excess returns are positively correlated (+18%).26 With the prospect for higher rates resulting from tighter monetary policy, longer-duration growth exposures (cash payments further out in maturity like a long-duration bond) could be further challenged from a total return perspective.
Fiscal policy could also detract from growth stocks’ luster in 2022. The financing of President Biden’s Build Back Better (BBB) spending package calls for corporations with over $1 billion in revenue in the past year to pay a minimum 15% tax. Based on our analysis, the magnitude of stocks affected is low (11% of the S&P 500).27 Yet, there are parts of the market that could be impacted on a more granular level.
The Technology and Communication Services sectors hold 33% of the 56 potentially impacted stocks.28 Even though some stocks in those sectors may not be directly impacted, those two sectors make up roughly 60% of a traditional growth exposure.29 Regulatory restrictions, another major focus during Biden’s presidential campaign, also could be in play. And, if BBB is passed, regulatory oversight on “Big Tech” could become more of an emphasis in Biden’s domestic agenda.30
While the growth witnessed in 2021 is likely to be the high point in this cycle, we are by no means approaching a trough. But the path ahead may become a bit more challenging than it was during the early stages of the recovery when less attention was paid to firm fundamentals and the “stocks only go up” mantra drove market action.
To navigate among the peaks of the next part of this rally, consider blending quality and value in the core with:
Quality and Value Multi-Factor Funds
High-Quality Dividend Strategies
1 Bloomberg Finance, L.P. as of November 11, 2021.
2 FactSet as of November 11, 2021, based on consensus analyst estimates.
3 FactSet as of November 11, 2021, based on consensus analyst estimates.
4 FactSet as of November 11, 2021. The 2022 consensus analyst estimates for the S&P 500 is 8.04% versus the 15-year average of 5.89%.
5 FactSet as of November 12, 2021.
6 “Hard Brexit Talk Returns as U.K. Eyes Suspending N. Ireland Deal”, Bloomberg, November 9, 2021.
7 Bloomberg Finance, L.P. as of November 11, 2021, based on consensus economist estimates.
8 Bloomberg Finance, L.P. as of November 11, 2021, based on the historical IMF World Gross Domestic Product Constant Prices Annual Percentage Change.
9 FactSet as of November 11, 2021, based on consensus analyst estimates for the S&P 500 Index and the MSCI ACWI Ex-US Index.
10 FactSet as of November 11, 2021, based on consensus analyst estimates for the MSCI Emerging Markets Index.
11 FactSet as of November 11, 2021, based on consensus analyst estimates for the MSCI EAFE Index.
12 FactSet as of November 11, 2021, based on consensus analyst estimates for the S&P 500 Index and MSCI EAFE Index.
13 FactSet as of November 11, 2021, based on consensus analyst estimates for the S&P 500 Index and MSCI EAFE Index.
14 Bloomberg Finance, L.P. as of November 11, 2021, per the MSCI Emerging Market Index.
15 Bloomberg Finance, L.P. as of November 11, 2021, based on the Bloomberg China Credit Impulse Index.
16 Bloomberg Finance, L.P. as of November 11, 2021, based on the Bloomberg China Credit Impulse Index and the MSCI China Index from 2010 to 2021.
17 Bloomberg Finance, L.P. as of November 11, 2021. Based on a non-rebalanced equal weighted composite of stocks in the Russell 3000 Index that had trailing negative 12-month earnings-per-share compared to a non-rebalanced equal weighted composite of stocks in the Russell 3000 Index that had trailing positive 12-month earnings-per-share. Stocks with an initial public offering (IPO) during the time frame were not considered, as the security needed to have a full period return to be included.
18 Bloomberg Finance, L.P. as of November 11, 2021. Based on a non-rebalanced equal weighted composite of stocks in the Russell 3000 Index that had trailing negative 12-month earnings-per-share compared to a non-rebalanced equal weighted composite of stocks in the Russell 3000 Index that had trailing positive 12-month earnings-per-share. Stocks with an initial public offering (IPO) during the time frame were not considered, as the security needed to have a full period return to be included.
19 Per Bloomberg Finance, L.P. Based on stocks in the Russell 3000 Index. Pre-pandemic is year-end 2019.
20 Bloomberg Finance L.P. as of November 10, 2021. Based on the performance of the Nomura US High Quality Long Index and the Nomura US High Quality Short Index, concentrated factor baskets that remove style and sector biases.
21 The metrics used for this analysis are: Price-to-sales (P/S), Price-to-book (P/B), Price-to-earnings (P/E), Price-to-next-twelve-month-earnings (P/E NTM), Enterprise Value-to-EBITDA (EV/EBITDA), Enterprise Value-to-sales (EV/S). Historical data from 2013 to 2021 per Bloomberg Finance L.P. as of November 11, 2021 based on SPDR Americas Research calculations.
22 Bloomberg Finance L.P. as of November 11, 2021 based on SPDR Americas Research calculations.
23 The metrics used for this analysis are: Price-to-sales (P/S), Price-to-book (P/B), Price-to-earnings (P/E), Price-to-next-twelve-month-earnings (P/E NTM), Enterprise Value-to-EBITDA (EV/EBITDA), Enterprise Value-to-sales (EV/S). Historical data from 1995 to 2021 per Bloomberg Finance L.P. as of November 11, 2021 based on SPDR Americas Research Calculations of the S&P 400 and S&P 600 Growth and S&P 400 and S&P 600 Value Index valuation metrics from 1995 to 2021.
24 FactSet as of November 11, 2021, based on the S&P 500, 400, and 600 Growth and Value Index constituents. Characteristics are as of the date indicated.
25 FactSet as of November 9, 2021, based on the S&P 500, 400, 600 Growth and Value Index constituents. Characteristics are as of the date indicated.
26 Bloomberg Finance, L.P. as of November 11, 2021, based on the correlation of the monthly excess returns of the S&P 500 Growth Index to the S&P 500 Index to the changes in the US 10-year yield as well as the monthly excess returns of the S&P 500 Value Index to the S&P 500 Index to the changes in the US 10-year yield from 1991 to 2021 based on SPDR Americas Research calculations.
27 Screened for firms with more than $1 billion in revenue in the past three years and less than a 15% tax rate in 2020 per Bloomberg Finance, L.P. data as of November 11, 2021 and SPDR Americas Research calculations. Characteristics are as of the date indicated and subject to change.
28 Screened for firms with more than $1 billion in revenue in the past three years and less than a 15% tax rate in 2020 per Bloomberg Finance, L.P. data as of November 11, 2021 and SPDR Americas Research calculations. Characteristics are as of the date indicated and subject to change.
29 Bloomberg Finance, L.P. as of November 11, 2021 based on the S&P 500 Growth Index.
30 “Biden nominates critic of surveillance software to FTC, further bolstering agency as check on Big Tech”, The Washington Post, September 13, 2021.
Basis Point (bps)
A unit of measure for interest rates, investment performance, pricing of investment services and other percentages in finance. One basis point is equal to one-hundredth of 1 percent, or 0.01%.
A measure of new lending as proportion of GDP and gauge of economic activity.
A grouping of equities, indexes, or other investment securities in a standardized way. When applied to stock prices, a composite index can provide a useful statistical measure for the performance of the overall market, a specific sector, or an industry group. Composites are also created for investment analysis of economic trends, to forecast market activity, and as benchmarks for the relative performance of professional money managers.
Earnings per Share (EPS)
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. It is common for a company to report EPS that is adjusted for extraordinary items and potential share dilution.
Emerging Markets (EM)
The economy of a developing nation that is becoming more engaged with global markets as it grows. Countries classified as emerging market economies are those with some, but not all, of the characteristics of a developed market. As an emerging market economy progresses it typically becomes more integrated with the global economy, as shown by increased liquidity in local debt and equity markets, increased trade volume and foreign direct investment, and the domestic development of modern financial and regulatory institutions.
Returns achieved above and beyond the return of a proxy. Excess returns will depend on a designated investment return comparison for analysis.
A strategy that focuses on companies that have the potential to grow their earnings at a high rate.
MSCI USA Index
An index designed to measure the performance of the large- and mid-cap segments of the US market. With 625 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US.
MSCI USA Quality Index
Based on the MSCI USA Index, its parent index, which includes large- and mid-cap stocks in the US equity market. The index aims to capture the performance of quality growth stocks by identifying stocks with high quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage. The MSCI Quality Indexes complement existing MSCI Factor Indexes and can provide an effective diversification role in a portfolio of factor strategies.
Characterized by firms with strong balance sheets and high profitablity.
A market breadth indicator that shows the relationship between the volumes of advancing and declining issues on an exchange. Investors typically use this indicator to determine the momentum of the market at any given time.
Characterized by lower price levels relative to fundamentals, such as earnings.
A numerical measurement that describes a value's relationship to the mean of a group of values. Z-score is measured in terms of standard deviations from the mean. In finance, Z-scores are measures of an observation's variability and can be used by traders to help determine market volatility.
The views expressed in this material are the views of Michael Arone, Matthew Bartolini and Anqi Dong through the period ended November 17, 2021 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.
This communication is not intended to be an investment recommendation or investment advice and should not be relied upon as such.
Past performance is not a reliable indicator of future performance.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA's express written consent.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Diversification does not ensure a profit or guarantee against loss.
Investing involves risk including the risk of loss of principal.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Returns on investments in stocks of large U.S. companies could trail the returns on investments in stocks of smaller and mid-sized companies.
Non-diversified funds may invest in a relatively small number of issuers, a decline in the market value may affect its value more than if it invested in a larger number of issuers. While the Fund is expected to operate as a diversified fund, it may become non-diversified for periods of time solely as a result of changes in the composition of its benchmark index.
Passively managed funds hold a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.
A “value” style of investing emphasizes undervalued companies with characteristics for improved valuations. This style of investing is subject to the risk that the valuations never improve or that the returns on “value” equity securities are less than returns on other styles of investing or the overall stock market.
Although subject to the risks of common stocks, low volatility stocks are seen as having a lower risk profile than the overall markets. However, a fund that invests in low volatility stocks may not produce investment exposure that has lower variability to changes in such stocks’ price levels.
A “quality” style of investing emphasizes companies with high returns, stable earnings, and low financial leverage. This style of investing is subject to the risk that the past performance of these companies does not continue or that the returns on “quality” equity securities are less than returns on other styles of investing or the overall stock market.
While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
Foreign (non-U.S.) securities may be subject to greater political, economic, environmental, credit and information risks. Foreign securities may be subject to higher volatility than U.S. securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets.
The funds or securities referred to herein are not sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability with respect to any such funds or securities or any index on which such funds or securities are based. The Prospectus contains a more detailed description of the limited relationship MSCI has with SSGA Funds Management, Inc and any related funds.