Is the stock market pricing in a V‑shaped recovery?

Background

As fears of COVID‑19 and its economic impacts set in, the value of the US stock market dropped by around 35 percent from its all-time peak on February 19, 2020. However, since the trough on March 23, the stock market has quickly bounced back and was less than 10 percent below its peak by the end of June. While the S&P 500 Index has benefited from the strong performance of tech giants, the recovery appeared to be broad-based, with all but one sector up by at least 30 percent from the trough. The numbers are broadly similar for the S&P/TSX Composite Index.

The magnitude and speed of the recovery have been unprecedented, largely because of swift policy responses from central banks and governments around the world. Stock markets were further buttressed by psychological factors resulting from mindsets such as “don’t fight the Fed,” “a fear of missing out” and “there is no alternative.” As a result, major equity indexes seem to reflect a V‑shaped economic recovery despite a sharp contraction in economic activities and corporate earnings as well as simmering geopolitical tensions.

However, investors have not been as optimistic regarding stocks that are more sensitive to the business cycle. Since the market peak, stocks with a high ratio of book equity to market equity (BE/ME) have continued to underperform stocks with a relatively low BE/ME. Given that prices of relatively high BE/ME stocks are more sensitive to changes in near-term cash flows and by extension to business cycles, this suggests that stock markets are in fact pricing in a slower and shallower economic recovery—not a V‑shaped one.

Stocks with a relatively high BE/ME tend to underperform in bad times

Stocks with a relatively high BE/ME, known as value stocks, tend to be of established companies that operate with more long-term tangible assets and offer relatively high dividend yields. In contrast, stocks with a relatively low BE/ME, or growth stocks, tend to be of young but fast-growing companies without many tangible assets or much dividend history. Despite the strong fundamentals of value firms, their stocks tend to trade at a lower price compared with the stocks of their industry peers. As a result, they have historically earned higher returns than growth stocks (Rosenberg, Reid and Lanstein 1985). This persistent difference in returns is known as the value premium in the literature. A leading explanation of this premium is that it compensates for the underperformance of value stocks in bad times.

One reason value firms underperform in bad times is that their cash flows tend to be more sensitive to the business cycle (Koijen, Lustig and Van Nieuwerburgh 2017). As mentioned, value firms tend to have more long-term tangible assets, such as manufacturing plants and equipment, which cannot be easily liquidated. This makes it difficult for them to reduce their costs in response to a shock (Zhang 2005). Moreover, dividends of value stocks are more front-loaded, while those of growth stocks are typically more back-loaded. Since stocks are often valued in terms of the net present value of their future dividends, prices of value stocks are more sensitive to shocks in the near-term dividends; hence, value stocks underperform growth stocks in bad times (Lettau and Wachter 2007).

This time was not different

Consistent with the literature, value stocks have sharply underperformed growth stocks following the COVID‑19 shock. I illustrate this by following Fama and French (1993) and constructing a High Minus Low (HML) portfolio, which essentially measures the difference between the returns on value-stock and growth-stock portfolios.

Chart 1 shows the poor performance of the HML portfolio since the start of the COVID‑19 crisis. From the market peak on February 19 to the market trough on March 23, the value of the US stock market dropped by around 35 percent. During this period, value stocks underperformed growth stocks by around 20 percent (red line). While the stock market quickly bounced back to less than 10 percent below its peak by the end of June, the HML portfolio continued to underperform. Simply put, an investor in the HML portfolio would have lost more than 20 percent from February 19 to the end of June, while an investor in the broad stock market portfolio would have lost less than 10 percent during the same period.

The performance of the HML portfolio captures key events in the sample period. This suggests that investors viewed value stocks more favourably than growth stocks when the near-term economic uncertainty had abated significantly. For example, the HML portfolio generated large positive returns in response to the announcement of additional stimulus from the Federal Reserve, the news of promising test results of a potential COVID‑19 treatment drug (Remdesivir) and an unexpected rebound in the US labour market. However, these positive returns were fully reversed in the subsequent weeks while the broad stock market continued to rally.

Chart 1: Value stocks have sharply underperformed growth stocks in the United States

Source: Kenneth R. French data library and Bank of Canada calculationsLast observation: June 30, 2020

The underperformance of the HML portfolio is not entirely driven by the top-performing growth stocks, such as Facebook, Apple, Amazon, Microsoft and Google (FAAMG). Analyzing the performance of the HML portfolio on a more granular level reveals consistent results across HML portfolios constructed using the stocks of firms of different sizes. Chart 2 shows that most value stocks have sharply underperformed growth stocks across different sizes. In other words, investors have not been as optimistic regarding stocks that are more sensitive to the business cycle. In contrast to the performance of the broad stock market, this suggests that stock markets are in fact pricing in a slower and shallower economic recovery.

Chart 2: Performance of 25 portfolios by size and the ratio of book to market equity (BE/ME)

Source: Kenneth R. French data library and Bank of Canada calculationsLast observation: June 30, 2020

Looking ahead

The rapid recovery in the stock market should be interpreted with caution. While major equity indexes have climbed back to near their all-time highs, investors have not been as optimistic regarding stocks that are more sensitive to the business cycle. As such, stock markets are actually pricing in a slower and shallower economic recovery—not a V‑shaped one.

To be clear, this finding does not necessarily indicate that stock markets are currently overvalued. Rather, it reflects that major equity indexes such as the S&P 500 are dominated by growth stocks, which should on average better absorb negative shocks than value stocks do. On top of this, the top-performing FAAMG stocks, which account for more than 20 percent of total S&P market capitalization, are widely regarded as beneficiaries of the pandemic because it has accelerated structural change toward digitalization. Whether or not FAAMG or growth stocks in general are overvalued is a question I leave for the investment community.

References

1. Fama, E. F. and K. R. French. 1993. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics 33: 3–56.
2. Koijen, R. S. J., H. Lustig and S. van Nieuwerburgh. 2017. “The Cross-Section and Time Series of Stock and Bond Returns.” Journal of Monetary Economics 88: 50–69.
3. Lettau, M. and J. Wachter. 2007. “Why Is Long-Horizon Equity Less Risky? A Duration-Based Explanation of the Value Premium.” Journal of Finance 62 (1): 55–92.
4. Rosenberg, B., K. Reid and R. Lanstein. 1985. “Persuasive Evidence of Market Inefficiency.” Journal of Portfolio Management 11 (3): 9–16.
5. Zhang, L. 2005. “The Value Premium.” Journal of Finance 60 (1): 67–103.