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Valuation Analysis – Time to Reconsider Large Cap Value & Growth Allocations

Applied Finance has calculated Valuations of major indices on a monthly basis since September of 1998. Calculating the Intrinsic Value upside/downside of every company in an index such as the Russell 1000, we can then take the median and track the results over time to determine how the market looks on a relative basis today vs the past 22 years.

The charts below show the median Valuation upside/downside relative to the long-term average. Also plotted are -1.5 (red) and +1.5 (green) standard deviation lines. The general trend since the late 90’s is that the market is almost always inside the green and red lines, a sort of “zone of reasonableness”, where the market isn’t trading at an excessive premium or discount. On a few occasions however, the market can go below the red line (signaling an overvalued market), or above the green line (signaling an undervalued market).

Prior to 2020, we saw two distinct periods of imbalance in the Russell 1000. During the late 90’s Tech Bubble, Valuations crossed below the red “overvalued” line and led to three years of negative returns (2000, 2001, & 2002). Second, during the 2008 Financial Crisis, stocks appeared significantly undervalued. Large caps also briefly looked undervalued around the end of 2011 during the US Fiscal Deficit talks.

In 2020, we’ve seen two major swings. At the end of March in 2020 during the initial Coronavirus panic, stocks sold off and looked undervalued. As both monetary and fiscal stimulus gave investors hope over the late spring and summer, stocks pushed to new highs. Today, large caps look mildly overvalued, just crossing the red barrier at the end of August.

Dividing large cap stocks into value and growth styles, we can see a divergence in relative attractiveness. Note that historically, large value stocks have seen dramatic up and down swings in Valuation. At the peak of the Tech Bubble, Large value stocks actually looked undervalued (see late 1999 in chart below). As the economy entered recession later in 2001 and 2002, value stocks then became marginally overvalued as profitability suffered. In the 2008 crisis, a similar dynamic occurred. In the trough of the crash, large value stocks looked incredibly undervalued. As stocks recovered in 2009 and 2010, they again briefly looked overvalued as profitability lagged.

In 2020, we again saw large value stocks appear undervalued in the height of the panic, and now appear around their long-term average. Note that in the current period we have not seen value stocks recover as strongly. In the two previous recessions, value stocks significantly outperformed in the initial recovery. Today, it is possible that there is more upside for this segment.

Growth stocks historically have seen fewer, but more pronounced moves in relative Valuation. Growth companies became dramatically overvalued in the early 2000’s Tech Bubble as internet stocks with little to no profitability rose. The chart below shows large cap growth names significantly overvalued for nearly 3 years from 1999-2001. As stocks fell and profitability improved in the early 2000’s, valuations normalized. Then, during the 2008 crisis, growth stocks looked attractive when markets fell. Since the aftermath of ’08, they’ve traded in a normalized zone until recently. This is an important point to make: Investors have talked about growth being overvalued for years, but we only see it recently. As interest rates & interest rate expectations fell following the Financial Crisis, growth did well as investors adjusted expectations for discount rates and more distant cash flows became relatively more valuable. In the past 2-3 months, growth stocks have just crossed over the red warning line and currently appear overvalued. Today we would caution growth investors to be wary.

We can also examine the relative value/growth skew. In the chart below, a higher percentage represents relative value attractiveness, while a lower percentage represents relative growth attractiveness. The chart outlines a few major trends since the late 90’s:

  • During the Tech Bubble, value looked dramatically more attractive than growth
  • Value vs growth attractiveness looks indifferent most of the time
  • Mild value attractiveness during late 2008 into 2009
  • Value recently began looking more attractive than growth, exacerbated by Covid-19, but not as extreme as during the Tech Bubble

To conclude, aggregate Valuations of broad indices usually are in a relative band; stocks tend to trade within a “zone of reasonableness” most of the time. On a few occasions however, extreme events can push stocks to become excessively over or undervalued. Applied Finance generally talks about two periods of disparity prior to 2020: the late 90’s Tech Bubble where stocks were overvalued, and the 2008 Financial Crisis where stocks were undervalued. In the current market, we see a difference in Valuation between value and growth names. Value stocks appear to be around their long-term normal range from a relative attractiveness standpoint. Growth companies however, appear to have become overvalued in recent months.

Timing market emotions is a difficult task. Applied Finance focuses on constructing portfolios from undervalued companies, regardless of their arbitrary “growth” or “value” classification. From a strategic perspective, investors should be wary of the great growth rally, as it’s no longer supported through normal valuations.

9/30/1998 – 8/31/2020
All Median Valuation figures normalized to long-term average of each Index/Partition.
Value/Growth partitions use Applied Finance MVIC criteria.

About John Holt, CFA 8 Articles

John Holt, CFA joined Applied Finance in 2014 and is involved in the management of both quantitative strategies and analyst driven strategies.