Markets in focus: Stretched factors
4 June 2020
Phil Mackintosh, Nasdaq Chief Economist, has 28 years of experience in the Finance industry, including roles on the sell-side, buy-side and at accounting firms, which included managing trading, research and risk teams. He is an expert in index construction and ETF trading and has published extensive research on trading, ETFs and market structure.

Over the past decade, as global interest rates have fallen and remained low, some of the typical portfolio factors have seen extremely long periods of over- (and under-) performance that now leave them at or near multi-decade highs (or lows depending on your exposure).

Let’s look at some simple ratios for traditional portfolio construction factors.

Chart 1: Growth beats value

For most of the last 14 years, growth has been beating value. That is an unusually long run of relative outperformance. The recent market volatility has extended that outperformance, back to levels not seen since the tech bubble in 2000.

Low interest rates provide some rationale for growth outperformance. With long-term rates used as the “discount” factor applied to earnings, a very low rate of interest makes future revenues expected for 2030 count for more now than in years past. That in turn helps growth stock valuations more, because (by definition) their earnings are expected to grow more the longer into the future we look.

However, a few factors make this time different from the tech bubble two decades ago. Firstly, many growth companies today have revenue and cash flow. There is also concern that deflation has been caused by demographics and global trade, and that might keep nominal interest rates lower for longer.

The thing to watch, as we recover from COVID-19, is whether all the fiscal stimulus instead causes inflation, as that would probably cause rates to rise.

Chart 2: Size matters: Large beats small

Size is another classic portfolio attribution factor.

Data shows that small-cap stocks have underperformed since 2011, returning 88% vs. large caps’ 143% as the market rallied.

Despite that, small caps have held their gains made right after the tech bubble, returning 188% vs. large caps’ 140% over that time (from December 2000 through May 2020). Although that’s partly because some missed the tech rally.

It’s a little surprising small caps haven’t performed better through the rally over the past decade, especially given their higher beta and volatility (18% vs. large caps’ 16%). But that’s also consistent with other scores that show mega caps have outperformed as the rally has aged.

Chart 3: U.S. beats international

Finally, we compare the U.S. equity market to international stocks. This shows the dominance of the U.S. equity market for investor returns. U.S. stocks have outperformed almost constantly since 1990. In fact, although the tech bubble and the credit crisis were U.S.-driven events, the hiccups they caused the U.S. market were relatively small and brief.

As we saw for growth, the COVID-19 selloff has added to the U.S. market outperformance. That’s partly because of the U.S. markets larger “new economy” exposure. Something we talked about recently contributing to this years’ Nasdaq-100 outperformance too.

We think it’s also because U.S. markets are attractive to many of the world’s best companies and entrepreneurs. Based on MSCI indexes, U.S. markets have increased around 847% compared to the rest of the world’s 84% from 1990 through 2019. This suggests that U.S. markets have added around $12 trillion more wealth to investors over this time.

That’s something we need to protect.

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