Business

Value Stocks At 20 Year Discount: Is A Late Cycle Emerging?

Late Cycle? The U.S. Federal Reserve did not hike interest rates in September, so all eyes are turning to December as the next possible timeframe. Meanwhile U.S. equities as a whole continue climbing, although Barclays strategists say value stocks are near their cheapest levels compared to quality stocks in 20 years. In fact, investors are clearly skeptical about the current market conditions as Barclays warns that some late-cycle risks are beginning to emerge.

Are the markets moving into a late cycle?

The markets move into a late cycle when the economy is close to slipping into a recession. However, what’s particularly interesting is that right now, there are some contradictions, meaning that the markets aren’t showing all of the signs of a late cycle. Usually a late cycle is marked by extremely high investor sentiment, but right now we’re seeing tepid enthusiasm at best.

Among the signs of a late cycle outlined by Barclays strategist Dennis Jose and team in their report titled “Welcome to the ‘late-cycle'” is a maturing profits cycle in the U.S. The Fed’s continuing tightening and repeated delays in raising interest rates are further signs that the markets are slipping into a late cycle. Additionally, they note that leverage is on the rise in China.

A key contradiction to their late cycle theory is the lack of enthusiasm on Wall Street. The Barclays team calls sentiment “sceptical at best,” noting that current valuations remain “well below prior bull market highs.

Late Cycle
Late Cycle

[drizzle]This makes the current market environment unlike what we observed in 2000 and 2007, which were late cycle years.

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They believe that if the Fed does raise rates in December, the markets could see a correction but not a collapse.

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They add that if a recession doesn’t arrive soon, the valuations should re-rate higher. However, analyst sentiment also looks low right now, which again is opposite of what we saw in those two years, and analysts are capitulating on their previous forecasts for earnings growth.

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On the other hand, they warn that cash levels in European funds look high. In fact, they say the percentage of cash as total assets is nearing where it was during the financial crisis.

Late cycle –  Flee to value stocks or growth stocks

So what’s an equity investor to do during a time of such contradiction? Jose and team believe that a potential turn in interest rates makes value stocks more attractive than quality stocks. They note that value stocks are hovering near 20-year lows.

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However, investors who want to invest for more than just the potential outcome may instead turn to growth stocks instead because the Barclays team feels they look cheap no matter what happens to interest rates. In fact, while analysts have generally been scaling back their forecasts for earnings growth, they’ve been moving in the opposite direction on growth stocks, boosting their forecasts.

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The Barclays team states that currently valuations are only high in quality stocks and not in growth or value stocks. This again is the opposite of what we saw in 2000 and 2007, when the valuations of all three types were high due to extremely high investor sentiment. Investors tend to hide in quality stocks during bear markets, but Jose and team advises against this right now because of the high valuations.

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As bond yields turn, however, the markets could rotate into value stocks from quality.

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They prefer cyclicals and are overweight Consumer Discretionary, Financials, Industrials, Technology, Healthcare and Telecom. They’re underweight Consumer Staples, Energy, Materials and Utilities.

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