How markets tend to ­overshoot fundamentals

Chas Craig, BridgeTower Media Newswires

As the economic impacts of COVID-19 reverberate through financial markets, today we use historical data for the two broad groupings of stocks, value and growth, to illustrate how markets tend to overshoot fundamentals to the upside and the downside.

As a group, value stocks trade at lower prices relative to earnings and/or net assets than do growth stocks, but their fundamental business prospects are generally not as promising. Our position is that a growth style and a value style at the index level are likely to earn similar rates of return over long periods, which has generally been the experience in recent decades. This makes sense, as all these companies operate in the same economy.

However, the returns for growth stocks as a group have historically been more volatile than for value stocks. This too makes sense given that growth investing at the individual stock level is a game of home runs and strikeouts, whereas value investing is more a game of base hits and groundouts. However, if prices are attractive relative to business fundamentals, this higher expected volatility should not preclude an investor from favoring growth stocks over value stocks, for if the price is right, a growth stock or group of growth stocks can be a better value than a stock or group of stocks that have been categorized as "value" by an index provider.

An important caveat to our somewhat agnostic view between value and growth styles, dogmatically defined, is that if starting valuations are abnormally high for one of the groups, future relative returns are likely to be subpar. Indeed, growth stocks, led by large-cap technology companies, massively outperformed value-style stocks in the decade ended 2019. The cumulative 10-years ending Dec. 31, 2019 change in price and 3-year average earnings per share (the average of 2017-2019 vs. 2007-2009) for the S&P 500 Value Index were 139% and 125% respectively, resulting in a P/E multiple expansion of 14%. By contrast, the S&P 500 Growth Index increased in price by 229% while earnings increased by just 86%, with the difference of 143% representing the expansion in the P/E multiple. Therefore, valuation expansion, not earnings growth, explains the outperformance of growth over value in recent years. This result is consistent with the decade ending Dec. 31, 2009, a period in which growth stocks underperformed in the stock market as the tech bubble unwound despite significantly better earnings gains than those achieved by value-style companies.

Our takeaway: Markets are said to be forward-looking. However, while Mr. Market correctly predicted future relative fundamentals directionally for value and growth stocks in the prior two decades, the magnitude to which the areas with the best business prospects got bid up in the market resulted in poor forward relative market returns as the actual fundamentals, while good, did not live up to the hype of the high starting valuations.

Regarding the implications of our observations herein to current events, nobody can predict the timing and level of a bottom in the stock market. However, we do expect that stock prices will overshoot fundamentals to the downside and that prices will bottom before the fundamental situation does.

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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).

Published: Mon, Mar 30, 2020

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