Value Stocks Are Breaking Out. Hooray?

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A rotational shift with an ominous subtext leads market commentary.

It’s been a long time since value stocks were in favor. Just ask David Einhorn, whose main hedge fund lost 19 percent through the first seven months of 2018 in a misguided bet that investors would come to their senses and start scooping up stocks that were cheap and had actual earnings. Value last outperformed growth on a quarterly basis in the final three months of 2016. But suddenly, more strategists are saying a budding rally in value may finally be the real deal after years of false starts.

Since July 20, the Russell 1000 Value Index has gained 2.45 percent, topping the 0.83 percent increase in the Russell 1000 Growth Index, whose smaller advance reflects some high-profile earnings setbacks at companies including Facebook Inc. and Netflix Inc. Of course, it will take a lot more than a couple of weeks of outperformance to declare value is back and erase a decade of underperformance.

However, the headwinds facing equities in general and the economy more broadly are only getting stronger, which should at least boost the appeal of stocks that have such defensive characteristics as relatively low price-to-earnings ratios and a solid history of steady dividend payouts. Some of the challenges facing equities include a Federal Reserve that is accelerating the pace at which it’s withdrawing cash from the financial system, and the growing sense that the rising U.S. debt and deficits combined with escalating trade tensions will cause growth to slow. At $4.256 trillion, the Fed’s balance sheet assets have shrunk by $190 billion this year.

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“The Fed basically tells you what to do,” Jared Dillian, a Bloomberg Opinion contributor and editor of The Daily Dirtnap, recently wrote in the newsletter. “For most of the last 10 years, the Fed was telling you to take risk. Now it is telling you not to take risk.” Rarely have value stocks looked more appealing on a relative basis, with the forward price-to-earnings ratio for the Russell 1000 Growth Index at about 22.1 times, compared with 15.3 times for the Russell 1000 Value Index.

BOND TEST: For many years, debt and deficits hardly mattered to markets — at least those in the U.S. But lately there’s been a lot of hand-wringing over the trajectory of the U.S. budget deficit and increased borrowing. The bipartisan Congressional Budget Office is forecasting trillion-dollar deficits as a result of lost revenue from the Trump administration’s tax overhaul. The amount of government debt outstanding, which has more than tripled since 2007 to $15 trillion, is now predicted to grow even more just as the Fed steps back. This week will provide a big test of investor demand as the Treasury Department auctions $78 billion of three-, 10- and 30-year bonds starting Tuesday. Though the bond apocalypse may be coming, it’s unlikely to happen before Sept. 15. In a note to clients Monday, Cumberland Advisors Chairman and Chief Investment Officer David Kotok noted that one reason demand for bonds has held up, especially for longer-term maturities, may be because of pending tax-law changes. Kotok points out that companies with an unfunded defined-benefit pension liability can take a tax deduction at the old 35 percent corporate tax rate if they fund it before Sept. 15. After that date, the deduction rate drops to 21 percent. Buying longer-term bonds and related securities allows companies to lock in the funding of their pension liabilities, which bolsters their creditworthiness in the eyes of ratings firms. In that sense, perhaps the bond market’s expiration date is Sept. 15.

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