Time to Buy Value Stocks?

By Ketu Desai

The markets got a punch in the gut late in November. The new variant is largely to blame, but the market was weak for most of the month. The Russell coming into Black Friday was already down 6 percent and the average stock down similar levels. The action beneath the surface has been very weak. The market was taking down sectors one by one in November prior to Black Friday. Unprofitable high growth tech names feeling the most pain. The big indices have been held up by a few large cap names, particularly in semiconductors and electric vehicles. While I don't have the data to prove this yet, the sell-off did feel like it was due to forced selling, perhaps margin calls, or redemptions from a big hedge fund, and the algos just piled on.

The investments related to inflation, reopening, and higher rates took it the worst the last few days of the month. The new variant has already led to some travel restrictions, and the market is fearful that we may go back into lockdowns. I think you want to remain in these investments and perhaps even consider adding to these investments. If the variant is bad, the supply chain problems are unlikely to improve, and will probably worsen, which is inflationary. The labor shortages are also unlikely to get better and probably worsen. This means higher wages. In general, if the variant is bad, we get supply driven inflation. Further, there is the potential for more fiscal stimulus. The Fed could possibly reverse the taper, meaning a higher money supply, and higher inflation. If the variant is bad, this will make the inflation problem probably worse, and the Fed will have less tools to fight it, this will benefit the inflation and higher rate trades.

If the variant is not bad, then we still have the same supply problems as we did prior to the variant, but we have more demand driven inflation. The latest CPI reading was above 6 percent, the highest since 1990. The growth picture would remain intact, of 4 percent or so GDP growth next year and high-single digit to low double-digit earnings growth. With cyclical sectors leading the earnings growth. We would start to feel the impact of the infrastructure bill, likely have a new corporate cap ex cycle, large inventory restocking, and most importantly a strong consumer that is ready to get back to normal. This backdrop of high inflation and above trend economic growth, again favors the higher inflation and higher rate trades.

I think energy and financials are the best way to play it. In a world where most asset classes (both private and public) are fairly valued to overvalued these areas are actually cheap. The S&P trades at 22.5x and the 10YR trades at 68x “earnings". Energy trades at just 12x earnings and financials at 13x. Not only do they trade at steep discount, they offer significantly higher cash yields. Energy offers a 4% dividend yield, and financials a 2.25% dividend yield and a 5%+ total shareholder return. Energy offers the highest free cash flow and dividend yield in the S&P, while having the best earnings momentum. Despite the variant, the risk remains skewed towards higher inflation and rates. This is different than the previous cycle when deflation and growth fears reigned. In that environment, investors paid any price for growth. Valuation didn't matter. Valuation will matter if we move to an environment of higher rates and inflation. This will mean a change in leadership to the value stocks.

Looking forward, the market will continue to focus on the virus, the latest out of Washington and Fed, and the economic data.

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Ketu Desai is the Principal of i-squared Wealth Management Inc. ( www.isquaredwealth.com ), an investment management firm based in New Jersey. ketu@isquaredwealth.com