With the possibility of an improvement in the economic situation and the growing expectation of a Fed rate cut, these undervalued stocks are about to encounter a good opportunity for rebound.
Since the beginning of the year, the S&P 500 Index has far outpaced the Vanguard S&P 500 Value Index Fund.
Value stocks have recently performed poorly, but several factors in the future may boost them.
The Vanguard S&P 500 Value Index Fund, which tracks the components of the S&P 500 Index, only rose by 5% this year by trading at low multiples of expected earnings per share over the next 12 months. This is in contrast to the 15% increase in the S&P 500 Index, which seems to pale in comparison.
Value index funds have rebounded briefly several times, but each time there were sellers entering the market at the high point of 180 USD. The price as of Tuesday afternoon was 175 USD.
The problem lies in the fact that the economic situation is crucial to value stocks, and investors lack confidence in their future prospects, which makes it difficult for stock prices to rise. Value stocks are usually mature companies, whose profits are more affected by changes in consumer and business demand, rather than industry-specific factors affecting young growth companies, such as banks, relative to solar panel manufacturers that rely on renewable energy for transformation.
The current problem is that economic growth is slowing down. Although the market hopes that a decrease in the inflation rate will prompt the Federal Reserve to cut interest rates to maintain economic growth, this outcome is still uncertain. This makes people worry that economic growth is slowing down while interest rates remain high, which is a disadvantageous combination for value stocks.
In view of this, value stocks have performed so poorly that they are expected to rebound, especially as the economic situation may improve.
The price of the value fund is only slightly higher than its 200-day moving average of 166 USD, which is a positive signal. FactSet data shows that buyers have always entered the market near the 200-day moving average for over 20 years, except for major negative events such as the pandemic and the rapid rate hike by the Federal Reserve in early 2022.
Unless a severe unexpected event occurs, value stocks should stabilize at their current level. Their valuation is unusually cheap.
The P/E ratio of the value fund is currently about 15.8 times, which is about 26% lower than the P/E ratio of the S&P 500 Index of 21.1 times. According to calculations using FactSet data by Barron's, the discount of the value fund relative to the large cap index has averaged about 17% over the past 10 years.
Changes in economic expectations (reflected in bond prices) may cause stock prices to jump.
Although long-term bond yields are usually higher than short-term debt, the two-year Treasury yield is currently about 0.3 percentage points higher than the 10-year yield, close to the largest gap of the year. St. Louis Fed data shows that investors are concerned that the Federal Reserve will maintain high short-term interest rates, affecting commodity and service demand to curb inflation. Long-term yields are lower than the two-year yield because of concerns that the current Fed policy will continue to depress long-term inflation due to economic weakness.
Once the Federal Reserve sends a signal of the first rate cut, the two-year yield should decline, and the market will have more confidence in long-term economic growth, which will push up the 10-year yield. This will bring about an improvement or "steepening" of the yield curve, which is usually beneficial to the economy.
"The steepening of the expected yield curve will support value factors," wrote Dennis Debchak of 22V Research.
Debchak identified value stocks that could participate in such a rebound. Among the 26 stocks he selected, 6 are well-known: General Motors (GM.N) ranked highest, followed by United Airlines (UAL.O), American Airlines Group (AAL.O), Ford Motor (F.N), Invesco, and Metlife (MET.N).
General Motors has risen by double digits this year, but is still 27% lower than the record low at the end of 2021. Its P/E ratio is only 4.9 times, close to the lowest level in the past 20 years, despite its significant increase in stock price this year. The company has carried out share buybacks so that its valuation has not become more expensive than at the beginning of the year.
American Airlines Group ranks third. It has performed negatively this year, with a P/E ratio of 4.6 times, which is also close to the historical low level.
Once the Federal Reserve sends out a stronger signal to cut interest rates, these stocks will be ready to rebound.