Value investing 'still makes sense’ in today’s market, says strategist
Value investing has seemingly faded into the background due to the continued hype surrounding the tech sector. J.P. Morgan Asset Management Global Market Strategist Jack Manley explains, "value has not worked this year", noting that investors did not expect the jump in growth stocks, such as the 'magnificent seven'. But as those stocks climb, investors are starting to grow concerned about valuation. As a result, Manly says that investors should be paying attention to value stocks going forward, stating "that's where the valuation opportunity lies."
Video transcript
- Berkshire Hathaway reported a staggering $36 billion in profit in the second quarter. Thanks to strong performances from top holdings, like Geico Insurance and a boost from rising interest rates. Earlier this year, the idea of value stocks making a comeback was doing the rounds. And Berkshire, of course, falls into that category.
So is there still value in the value stock by? Joining us now is Jack Manley, JP Morgan Asset Management global market strategist. Good to see you, Jack. Thanks for coming in.
JACK MANLEY: Thanks for having me.
- So let's talk sort of broadly about that idea of value, which I feel like we haven't talked much about lately, right. It hasn't been with the so-called Magnificent Seven or whatever dominating this year. Value has faded into the background. So how are you thinking about value right now.
JACK MANLEY: Yeah, you're right. I mean, value has not worked this year. And I think it's more frustrating because at the start of the year, everybody thought value was supposed to work. I don't think anybody really anticipated the jump higher in these growth year. Tech, and tech, adjacent names, the Magnificent Seven, as you mentioned.
But when we think about the recovery that we've seen in that particular pocket of the market, it has been driven overwhelmingly by multiple expansion, right. And what that's done is it's translated into an S&P 500 that is trading well north of its 25-year average in terms of price to earnings ratios. We're looking at almost 20 times, if not closing in on 21.
Markets, investors are starting to get a little bit nervous about that, right. They're seeing the indexes perhaps being overvalued at a time when earnings are looking only so-so. If you're looking to figure out what to do in the market that is not those Magnificent Seven, that is not those winners of the last call it seven or eight months, you have to look elsewhere.
And it's easy to forget that there are another 490 plus names in the S&P 500 that aren't doing a whole lot, haven't done a whole lot. That's where the valuation opportunity lies. It's where perhaps the earnings opportunity lies. And I think that tilts you more in favor of value of cyclicality. I think it still makes sense in today's environment.
- What's the key marker of a good value stock for anybody that's looking to add this to their portfolio then or at least kind of get more of a mindset around how they should be evaluating these companies?
JACK MANLEY: Yeah. I would say, first of all, valuations play a big role in this, right. And we know that value stocks typically trade at a fairly significant discount relative to growth. That discount is even more pronounced given the rally we've seen in those large cap growth tech and tech adjacent names.
But the other thing you want to look for is sustainability and quality in earnings growth, especially with the interest rate environment that we're in right now. We spend a lot of time talking about Fed policy. Everybody's more or less on the same page that at some point in the next call it six months, the Fed is likely going to start cutting. But when they cut, they're not taking rates back down to zero.
And so even if the interest rate environment gets better from where it is right now, you are still looking at a fundamentally different interest rate environment from where we were two years ago. And that tilts us in favor of a quality allocation. And I think that is a big component of that value play as well.
- So I have two questions on interest rates. Let's start with the first one, which is something that we've been talking about. With rates at the level where they are now, how much of a headwind is that going to continue to be for growth stocks?
JACK MANLEY: I think it depends what pocket of the growth market you're looking at. And I know that's sort of a wishy-washy answer. But it depends. There are some high flying, very speculative growth names out there in the index. I think a great example of that at a sort of sub sector level would be the craze in artificial intelligence.
I don't think anybody would argue that AI is not an exciting development. But I also think we're perhaps getting a little bit ahead of ourselves thinking that AI is going to fundamentally transform the world in the next six to 12 months. It's going to take a little bit longer than that.
Meanwhile, there are some other technology names out there with a proven track record of innovation that continue to put out product whatever that product may be. They have some sort of stability in that earnings growth, in what they're able to deliver. That's what I think the quality allocation looks like in the tech name. And I think that those companies can make money if rates are at 5%, or if rates are at 2%, or even obviously if rates are at 0%.
- OK, the other interest rate question I want to ask you is, you just said that everybody seems pretty convinced that the Fed is going to be cutting. Just as everybody was convinced that value was going to do well this year at the beginning of the year, everybody was convinced the Fed was going to cut this year. Guess what, the Fed ain't cutting this year. So how can you still be so confident and how can the market be so confident that the Fed is going to cut next year?
JACK MANLEY: Yeah. Well, look, I'm not trying to pat myself on the back here, but I never thought the Fed was going to cut this year.
- Fair enough. Fair enough.
JACK MANLEY: But beyond that, right, the thing about the Fed that I have learned, and it's been a really humbling experience as a market watcher. And you hear it time and time again, don't fight the Fed. But you also think, hey, maybe this time is a little bit different. And then you end up getting egg on your face, right.
You should not be fighting the Fed. And there is no reason right now to not take the Fed at face value. They tell us one more interest rate hike at some point this year. Hundreds basis points of cuts next year. 125 basis points of cuts the year after that. And with a long term fed funds rate of 2 and 1/2 percent, less than half of where we are right now. Thus far, in this hiking cycle, the Fed has not once failed to deliver on exactly what they told us they were going to do or more, right. They have never come in under expectations.
- It's just that the market didn't believe them.
JACK MANLEY: The market did not believe it. And you know what, for good reason. I don't think the data support what the Fed's been doing for the last three hikes. And I don't think the Fed should be hiking again later this year. I think we have a very clear disinflationary trend.
I think we have an economy that is very slowly, gradually moderating. So that's good news too. I don't think we should have hiked earlier this year after SVP. I don't think it should have happened after first Republic. I don't think it should have happened a couple of weeks ago.
I don't think it should happen in a couple of months. But my opinion doesn't matter. Jay Powell's opinion matters. And he wants to keep going. And I think that's what's going to happen. But then we reach that crest, and we start to move lower next year.
- But the risk there is that inflation never gets to their target if they don't institute some of those hikes as well.
JACK MANLEY: I sympathize with that. And the way I have the inflation conversation as it relates to the target, right, is that the Fed has maintained a 2% inflation target for almost 20 years at this point. And if they were willing to persistently tolerate an undershoot of that number, as long as it was within reason, right, I don't see why they wouldn't be able to tolerate a persistent overshoot of that number as long as it's within reason.
We know the Fed took rates down to zero. That is pretty extreme. We also know that 20 years ago, if you opened up an econ textbook, the concept of negative interest rates was an impossibility. It doesn't make any sense. And yet, we look at what the ECB did. We look at what the BOJ did.
The Fed could have done more with rates, and it chose not to. It was willing to tolerate inflation where it was. I don't think they moved the 2% target. I think if inflation settles in at around 3%, 2 and 1/2, 2 and 3/4. That is good enough for the Fed to declare victory. And Powell himself told us to expect cuts before we hit that 2% target anyway. Again, I would take him at face value.
- So then I guess the other question is, the other narrative that has shifted dramatically this year is from, absolutely there's going to be recession, to soft landing, maybe no recession at all, yada, yada, yada. If the Fed is going to be cutting next year, does that imply indeed there will be a recession? I think it was the Bloomberg market survey came out and said, most participants are expecting a recession by the end of next year.
JACK MANLEY: I don't think the Fed cutting next year signals a recession. I think that the Fed itself was on the fence about whether or not it would engineer a recession. At the most recent press conference, Powell said that recession is out of an-- out of the cards, right, so to speak. They're not projecting it happening next year. I think the Fed to your point, Brad, right, is trying to keep things tight, trying to keep things uncomfortable to wrangle in that inflation number. But it recognizes per that long term target that 5 and 1/2, 5 and 3/4 is not where it's going to be forever.
- But you were saying you don't think the Fed should have raised at the last couple, and it shouldn't raise again. Does that imply you think that it will push the economy into recession?
JACK MANLEY: I think probabilities are certainly higher. I think we're probably clearer for the rest of this year. You look at the resilience of the labor market. And fundamentally, that, to me, is the only thing that matters. Almost 70% of GDP comes from consumption. And if you're still employed, you're still getting a paycheck.
And if you're getting a paycheck, you can keep on spending. And that has been the engine of growth. That's what drove that second quarter GDP beat. So I think we're probably OK for this year. Next year, the probabilities have ticked up. And I think the Fed has a lot to do with that.
If you look at any recession over the last 60, 70 years, the one unifying factor, the one common denominator has been an overzealous Fed. I don't think this time-- I wouldn't say that this time is going to be different. But I also don't think that at least in the first half of next year, it's a done deal. A lot of surprises here.
- So even with today's activity, that may be pricing in a lot of what the Fed may do over the next or at least looking at the probabilities for what the Fed may do at their next few meetings here. How far out do you think the markets are looking? And investors are trying to get ahead of the Fed even if they're not trying to fight the Fed right now.
JACK MANLEY: Well, when we think about, at least from a valuation perspective, it is that next 12 month earnings look through. And it can get a little confusing when you're dealing with an earnings season like where we are right now. Because we can forget, is that all the earnings we're talking about have already happened. Markets don't care about that. They care about what's happening in the future.
And so while we can talk about second quarter earnings estimates coming in or second quarter earnings growth rather coming in better than we would have expected earlier, in first quarter earnings, growth being pretty robust, it's the next 12 months that matter. And I think what happens here is we have this narrative of recession, right.
And people have been talking about a recession as if it were an inevitability for almost two years at this point. And yet, it hasn't really happened. I think one thing that a lot of us are kind of on the same page on with the recession outlook is, look, even if it does happen, this is not going to be an '08 style recession. This is not going to be a 2020 style recession.
There are no major imbalances in this economy that have typically preceded. Those enormous drop offs in activity. And so if a recession does materialize over the next 12 months and it's not that bad, then maybe market can look straight through that on to sort of greener pastures, right. Better interest rate environment, cooler inflation, growth is good enough, employment is good enough. Earnings kind of grow into the multiples that we have right now, and nobody bats an eye. I think that's a possibility.
- Fingers crossed.
JACK MANLEY: Yeah, right.
- Jack, thanks for being here. Appreciate it. Jack Manley, JP Morgan Asset Management global market strategist. Good to catch up with you.
JACK MANLEY: Thank you.
