One thing that often gets ignored by financial media – perhaps intentionally because it makes for better ratings – is the very wide gap between Wall Street (stock returns) and Main Street (economic data).  These two things are not the same.  Not even close.  Next month’s employment report, retail sales data, or GDP report (if the Bureau of Economic Analysis ever reopens for the date to be calculated and reported) all look backwards.  It is usually several months into a recession before we know from the economic data that we’re in a recession.

The stock market, in contrast, discounts forward-looking expectations of corporate profits.  Consider these important words, working from right to left:

• Corporate Profits.  The stock market is not a measure of job creation, GDP, consumer spending, or economic growth.  The stock market reflects corporate profits – how much companies make less what they spend.  Adding further separation from the economy, the stock market does not reflect corporate profits for the trendy bakery on the corner, the massively popular technology start-up, or the local bowling alley.  Rather, the stock market represents corporate profits for a fraction of the economy – large, publicly traded companies.  And when the flawed and terribly outdated Dow Jones Industrial Average is the barometer of stocks, the stock market effectively represents corporate profits of just 10-15 domestic public companies.  This alone can obviously create huge disconnect between the stock market and the economy.
• Forward-Looking Expectations.  Again, economic data reflects the past.  The stock market reflects expectations about the future.  Past results and future expectations are obviously different things.  But many investors still fail to appreciate the difference.  Consider that you knew in advance, before anyone else, that Company XYZ will announce 110% profit growth versus last quarter when they report earnings.  This is clearly a strong measure of historic results.  But this information alone would arguably give you zero trading advantage from which to profit.  In order to benefit from this information, you would need to understand the expectations.  Is Company XYZ currently expected to grow at 200% for the next several quarters to where 110% would be disappointing and cause the stock to fall?  Stocks often win on bad news and lose on good news because it’s the expectations that matter.
• Discounts.  The stock market “discounts forward-looking expectations of corporate profits.”  The first word here – ‘discounts’ – may be the most important word because stock prices don’t just reflect forward-looking corporate profits of public companies.  Stock prices reflect these anticipated future profits discounted back at some interest rate.  And this “discount rate” is overwhelmingly important in the valuation of stock prices.  Changing the equity discount rate by just a small amount can have a huge impact on stock prices.  This means that no change in expected corporate profits is required to move stock prices.  Just a positive or negative change in investor sentiment – which sometimes swings as wildly as the mood of a pubescent teenager – will cause huge stock market movements.  If you’re looking for an explanation as to how the S&P 500 Index can lose -9.5%, gain +9.3%, and then lose -12.0% on consecutive days in March 2020, this is a big part of that explanation.   

Snowfall in Finland is above average this winter so I don’t know why the Knicks keep losing

It should be clear by now that there is a rational disconnect in statements such as, “Economic data this month has been really strong so I can’t figure out why stocks are declining.”  One might similarly surmise, “Snowfall in Finland is above average this winter so I don’t know why the Knicks keep losing.”

But perhaps you are not convinced of the large divide between economic forecasts and stock returns and still seek someone who can make successful economic forecasts to profit off those forecasts.  Let’s assume for a moment that you find a financial advisor who can project the economic future better than nearly everyone else in the history of economic forecasting – far better that the smartest and most successful professionals.  While the best investors and forecasters in the world tend to be correct in their economic forecasts roughly 55% of the time, we will assume that is child’s play for your advisor.  He or she trades on economic surprises with an astounding 75% success rate, almost certainly making your advisor the best economic forecaster of all time.

How much of a fee should this financial advisor charge for this historically unprecedented forecasting prowess?  Fees approaching 20% per year like the most successful hedge fund investor of all time?  According to a recent whitepaper, your omniscient advisor may be of no added value.  The paper, which uses historical economic data and stock market returns from 1992 – 2018, indicates that predicting economic surprises with a 75% success rate and then trading on them would have produced returns similar to that of a buy-and-hold investor who did absolutely nothing other than rebalance.  From the paper’s concluding paragraphs:

“Do short-term surprises hint at long-term risk-reward dynamics that can inform strategic asset allocation decisions?  In a word: no.  Surprises don’t matter for long-term returns…Our analysis of the relationship between economic surprises and asset returns yields two insights: First, the odds of successfully trading on surprises are low.  Second, what can seem consequential in the short run is irrelevant to the long-term investor.”

What should you be doing now

Like many fee-only financial advisors, we create an investment policy statement (IPS) for every client and occasionally update this IPS, as warranted by changes in a client’s life.  The investment policy statement is intended to guide the investment actions of both us and our clients. 

Not a single IPS describes a plan to raise cash when political uncertainty causes nervousness and then stay in cash until we feel better about the political climate.  Not one suggests that we shift the investment risk level based on what the “trusted” or “expert” prognosticators are saying.  There is nothing about changing the asset allocation based on what a neighbor, work colleague, college roommate, or Uber driver are doing with their own portfolios.

An IPS describes how the portfolio will remain prudently diversified across asset classes, styles, and risks in an attempt to reduce overall volatility.  It lays out a targeted risk level that is individually designed based on things like risk appetite, financial objectives, time horizon, and anticipated cash flow needs.  The IPS uses the important term of ‘discipline’ to describe the investment approach.  

On this note, Fidelity Investments published a study in 2017 of more than 6.5 million workplace retirement plan and IRA account holders.  The report titled “Ten Years Later” compared the investment returns of investors who sold all their stocks in 2008 to those who stayed invested.  Investors who maintained an allocation to stocks during the bear market saw their retirement account balances grow by 240% from pre-crisis levels at the beginning of 2008 to the end of 2017.  Those investors who moved to cash at some point during the market decline of 2008-2009, even if only for a few days, experienced gains of just 157% during the same time 10-year period.  The study highlighted a similar result when comparing those who stopped contributing to their retirement accounts during the bear market versus those who continued contributing despite market losses. 

The market will fluctuate

In hindsight, it is easy to speak about the benefits of maintaining a discipline during unsettling periods.  Losing hard-earned money in the stock market is not fun.  It is scary. Many investors understand the benefits of long-term discipline but the evidence suggests that few practice it.  

In a world of instant gratification, maintaining a discipline is difficult.  But the empirical evidence overwhelmingly falls on the side of maintaining a discipline over tactical trading based on news, speculation, or emotion if the objective is to achieve long-term financial success.  Subsequently, this is precisely why we believe that one of the most important things we can do to help our clients achieve their financial goals is to establish a portfolio that is allocated according to objectives and personal risk appetite and then to adhere to that discipline. 

When asked, nearly a century ago, whether he thought the stock market would go higher or lower, investor J.P. Morgan is famously said to have responded, “The market will fluctuate.”

The stock market will continue to fluctuate.  Up and down.  And employing an appropriately allocated, disciplined plan is the best way we know to achieve financial success through those inevitable ups and downs.

The history books will show no Wimbledon champion in 2020, no Boston Marathon winner, no Final Four participants, and no 2020 Summer Olympic medalists. Just a lot of asterisks. A graph of crude oil prices will show a point in April 2020 when the price fell below zero. 2020 college transcripts – in many cases – won’t have traditional letter grades – just a P or an F for pass or fail. Economic charts – like those for weekly unemployment claims – have been forced to dramatically expand the y-axis to incorporate the data plots for 2020. 

You are likely tired of hearing about the unprecedented events and incredulous aberrations of 2020. With this in mind, we apologize in advance for the following (and for the preceding). Given all that has transpired this year, it is entirely understandable that one of the most examined, discussed, and debated stories within the institutional investment world in 2020 has gone largely unnoticed by most retail investors. While the election, the economic recession, Covid-19, and the stock market volatility continue to garner the attention of mass media, it is the historically unprecedented disconnect between value and growth stocks that earns attention and debate deep within investment circles in 2020.

This is a good time to pause and explain:

1. What is meant by “value stocks” and “growth stocks”;
2. How unprecedented the value-growth disconnect is;
3. What has caused the disconnect; and
4. What specifically this means going forward.

What Is Meant by “Value Stocks” and “Growth Stocks”? 

I recently explained one of the most fundamentally misunderstood investing concepts to my kids: that when evaluating the cheapness or expensiveness of a stock, the stock’s price – in isolation – is literally of zero value. Zilch. I went on to explain how a stock priced at $3,000/share might be dramatically cheaper than a different stock priced at $1/share to engrain this concept.

When we own a share of stock, we own a percentage of the underlying company’s assets, future revenues, cash flows, etc. And when we evaluate whether a stock is cheap or expensive, we should compare the price per share to the cash flow per share, the earnings per share, the book value per share, the revenues per share, or some other fundamental measure.  

Furthermore, when we evaluate stocks using a ratio where price is the numerator and one of these fundamental measures like earnings is the denominator (such as price / earnings), value stocks are those that trade at a below average ratio. Conversely, growth stocks – which is just a pleasant way of saying expensive stocks – are the stocks that trade at an above average ratio.

Value stocks are companies such as Colgate-Palmolive, Campbell Soup, and Hanesbrands that sell boring, low-growth, low margin products like dish soap, toothpaste, chicken noodle soup, and underwear. Value stocks often have significant issues within their business that makes them cheap. Conversely, growth stocks are companies such as Apple, Amazon, Google, and Tesla. They tend to have an exciting narrative and trendy products.  

Most investors get far more excited about the second group of stocks than the first. This is a big part of why the story plays out as it does. Value investing owes some of its success to the lottery preference of human brains – an inherent behavioral desire we have to prefer long-shots at the racetrack or an exciting technology company with the small potential of a 20x return. Investors, as a result, pay more than they should for trendy growth stories or 100-1 race horses which, conversely, drives down their expected return.  

You may also be familiar with the concept of recency bias – the behavioral tendency of humans to extrapolate the recent past into the future. Recency bias in investing is a real thing and results in investors overestimating the persistence of high growth or high profitability. The historic reality is that growth and profitability are not very persistent because competition in a capitalist society erodes any profitability or growth advantage over time. Conversely, investors underestimate the ability of companies with depressed profitability to exceed the depressed expectations in the future. As a result, growth stocks often fail to live up to the implied expectations (which means they tend to be overpriced) and value stocks often tend to exceed the lowball expectations (which means they tend to be underpriced).

The Historic Disconnect Between Value and Growth Stocks

We just described some of the explanations for why value stocks should outperform their more expensive counterparts but does the historical data support these theories? Nearly a century of market data reflects the following: Investing in value stocks tends to result in a performance advantage of several percent per year relative to investing in growth stocks. Between 1927-2019, value stocks outperformed growth stocks by a calendar year average of 4.4%¹. The historical evidence is persistent (value works across long periods of time), pervasive (value works across sectors, countries, regions), and robust (value works across different measures such as price/book, price/earnings, etc.).

The economic advantage of value investing over time should be clear from the charts above. While not a free lunch that “wins” every day or every year, value investing has rewarded long-term investors with a very sizeable economic advantage. The value premium is not something that just exists in the US. It has been persistent and robust around the globe².

Yet over the first eight months of 2020, value stocks underperformed growth stocks by the largest calendar year margin ever (39.0%)³. The previous worst underperformance of value stocks came during the heart of the tech boom when growth stocks beat value stocks by 24% in 1999. The growth-value performance gap in 2020 runs circles around even the dot.com boom. It has not just been a 2020 phenomenon. Growth stocks have outperformed value stocks over the past decade by the widest margin ever: 8.8% per year as of August 31, 2020.

What Has Caused the Value – Growth Disconnect

The historic departure of the value premium have investors and academics asking the hugely important question: Is value investing broken?

Much has been written and said to address this question. If we are being intellectually honest, then we have to occasionally retest our hypotheses and question our assumptions in all facets of investing. And so we must assess whether value investing should have the same success in the future as it has in the past.

There are several rational theories that seek to explain the recent demise of value investing and for sake of brevity, here is a summarized narrative of each:

• Overcrowding Hypothesis: The return premium of value investing is well documented and popularized such that value investing has become overcrowded, thereby eliminating any premium in the future. The problem with this hypothesis is that value stocks have become significantly cheaper relative to growth stocks and the valuation spread has expanded. Were value investing to become overcrowded, we would have expected the valuation spread to have declined.
• Low Interest Rates Hypothesis: The perceived attractiveness of growth stocks tends to rely heavily or entirely on future cash flows (think of companies like Tesla, Snapchat, or Uber that are losing money now but anticipation of high profits in the future). These future profits have to be discounted to arrive at a present value. When interest rates decline – as they have for the past decade – the lower discount rate (or opportunity cost) results in a higher present value for those future cash flows. This hypothesis isn’t necessarily an argument that value is dead or broken – just that the declining rate environment of the past decade has favored growth stocks. If true, then any increase in interest rates in the future would be favorable for value stocks and unfavorable for growth stocks. And while this may provide a compelling explanation for the recent trend, the empirical data does not support this hypothesis.
• Conservative Accounting Hypothesis: The growing importance of intangible assets (think intellectual capital or successful clinical trials) that are not reflected on financial statements makes many growth stocks look artificially expensive and diminishes the benefit of valuation measures. While a valid criticism for some valuation measures (like price / book value), there are plenty of valuation measures that correct for or ignore these conservative account discrepancies. Using measures that define value and growth stocks without regard for intangible assets does not change the historically robust success of value investing.  

None of the popular hypotheses to explain the divide between value and growth performance really holds up when the underlying data is tested. Furthermore, the underlying data does not demonstrate that growth companies are any more profitable or that value companies are any less profitable. In fact, the profitability of growth stocks relative to value stocks has actually declined by 1% over the past 12 years. In isolation, this should have caused value stocks to outperform growth stocks during that stretch.

So, if value investing is not broken, what then explains the dramatic performance gap? In our view, Occam’s razor does. The simplest explanation appears to be the one that best explains the value-growth spread.

Specifically, the performance spread between value and growth seems driven simply by value stocks getting cheaper and growth stocks getting more expensive. Borrowing a line from fund investor Cliff Asness, “Investors are simply paying way more than usual for the stocks they love versus the ones they hate.” The charts below reflect the historically expensive valuations of growth stocks or – said differently – the historical cheapness of value stocks. The top chart shows that growth stocks in the United States are 6.0 standard deviations above their historic average valuation as compared to value stocks⁴. The bottom of the two charts shows the same historic expensiveness of growth stocks relative to value stocks outside the United States.

What This all Means for the Future

While it is not unprecedented for growth stocks to beat value stocks over extended time periods, the duration and magnitude of this growth outperformance is unprecedented on many counts. What’s more important than this historical data is where we stand today and what it all means going forward.

Depending on what metric we use to measure the valuation of value stocks relative to growth stocks, value stocks are trading somewhere between really cheap and their cheapest level ever. While these relative valuation measures are not useful as short-term trading indicators (because really cheap stocks can get even cheaper and really expensive stocks can get even more expensive), they are helpful as long-term allocation tools.

In the book Expectations Investing, revered investor, professor, and author Michael Mauboussin provided a succinct and powerful explanation for why value investing works:

Having been on the sell side for many years and then on the buy side, I can say categorically that the single greatest error I have observed among investment professionals is the failure to distinguish between knowledge of a company’s fundamentals and the expectations implied by the company’s stock price. If the fundamentals are good, investors want to buy the stock. If the fundamentals are bad, investors want to sell the stock. They do not, however, fully consider the expectations built into the price of the stock.

There is this perception among retail investors that if you buy great companies, you will do well as an investor. Nearly a century of data debunks this myth and yet – to Mauboussin’s point – investors continue to buy into it. To be clear: it is not about how great the company is. It has always been about how much you pay. It is about what expectations are built into the price.

In our view, the evidence suggests that investors are increasingly ignoring the expectations built into stock prices – overpaying for great companies and underpaying for the less great companies. We are not alone in suggesting that this is perhaps the single most important trend in the stock market. While there is no time table for how long the trend may continue, an eventual reversion seems likely. And if it is anything like reversions of the past, value investors are positioned to be handsomely rewarded.

Records show that organ donation elections vary dramatically from country to country. Consider two countries that neighbor Germany: Austria and Belgium. 99.9% of Austrian citizens and 98% of Belgian citizens are registered organ donors. In Germany, only 12% of citizens are organ donors.  It turns out that these dramatic differences are the result of opt-in or opt-out choices. In Austria and Belgium, citizens have to check a box to opt-out of the organ donation program. In Germany, citizens have to opt-in to the program. Rather than make a decision or change, people tend to take the path of least resistance.      

Insurance companies are not naïve to the tendencies of consumers. Get consumers to sign up for a plan and then change the terms, deductibles, price, etc. in future years knowing that consumers are unlikely to change to a competing plan. As a result of these consumer tendencies, the Medicare insurance providers are economically motivated to create low cost plans that attract consumers over a 1-2 year stretch and then flip the economics upside down in favor of the insurance company, knowing the consumer propensity is to renew again next year.

It may be natural to think that since you’re not taking any additional medications and you have not changed doctors, that you can likewise put Medicare on auto-pilot during open enrollment. This, in fact, tends to be a costly decision for nearly 9 out of 10 individuals.

With the annual Medicare open enrollment period (October 15 – December 7) nearly upon us, we thought it would be useful to highlight five common and expensive mistakes of Medicare open enrollment season. The biggest mistakes tend to be relying on auto-pilot but there are other important mistakes that consumers make each year during open enrollment. If you are on Medicare, you would be well served to assess whether any of these mistakes apply to your situation and to seek guidance if you are unsure before the open enrollment period is over.

1) You automatically renew last year’s Medicare Part D Prescription Drug plan without reviewing other options. 

Prescription drug plans can and do change dramatically from year-to-year. Yet research estimates that 87% of Medicare participants enroll in the same prescription drug plan as the prior year. Consider some of the most common Medicare Part D plan changes from one year to the next:

• Significant premium increases;
• New deductible hurdles before covering your medication;
• Changes to the preferred pharmacies; or
• Increased share of costs consumers must cover for drugs.

The discouraging reality is that only 13% of Medicare D participants change plans from one year to the next but 88% of participants have a better plan available to them with the savings ranging from $276 to $562 per year. This means that most Medicare participants are throwing away several hundred dollars per year by ignoring the opportunity to re-evaluate coverage.

The remedy for Medicare participants is simple. If you are enrolled in a Medicare Part D prescription drug plan, you should, without fail, visit the Medicare Plan Finder every year during the open enrollment period or have someone (a relative or health insurance agent) do it on your behalf. The Plan Finder makes it easy to enter your current medications, dosages, and preferred pharmacy and then to compare the costs of all plan options in your area. Its interface is user-friendly and the outputs provide a convenient way to compare options. Even if you have not changed medications or you are not taking prescription medications, the best plan for you last year may be far more costly than the best Medicare D plan this year.

One note of caution when comparing plans is to ignore the “Annual Drug Deductible” as this is a misleading data point (the deductible may not apply to all prescription drugs and ignores the copay). Instead, use the “Estimate of What YOU Will Pay for Drug Plan Premiums and Drug Costs” to determine the lowest cost option that is personalized to your unique situation.

2) You purchase the same Medicare D Prescription Drug Plan as your spouse.

You have been trained through life to buy insurance together with your spouse on a single policy through the same carrier to reduce costs and minimize complexity.  This is generally not an ideal strategy when it comes to Medicare D Prescription Drug plans. If neither you nor your spouse are taking any prescription medications, then it may be appropriate to be on the same low cost plan. Otherwise, both of you should independently go through the annual review process during open enrollment season to determine the best plan for each of you. There are no benefits to enrolling in the same plan since there are no Medicare Part D family discounts and you will be billed separately (usually deducted from your respective Social Security payments).

3) You fail to use the mail order option or enter your pharmacy(ies) of choice when using the Medicare Plan Finder to search Prescription Drug plans.

It is not uncommon for there to be significant price differences – hundreds of dollars per year – for prescription drugs, depending on where you get your medications. The Plan Finder makes it simple to evaluate the costs for mail order or for nearby pharmacies. In real-life examples, plans that have the same drug coverage can differ in price by over $1,000 for the calendar year, depending on the pharmacy where medications are purchased. 

4) You leave your Medicare Advantage plan on autopilot.

If you are enrolled in a Medicare Advantage plan, you are allowed to switch to a different Advantage plan during open enrollment each year without underwriting. As with the Medicare Prescription Drug plan, anyone enrolled in a Medicare Advantage plan should compare options each year during this open enrollment period. You can again use the same helpful Medicare Plan Finder to compare Medicare Advantage options in your area. It is valuable to compare premiums and out-of-pocket costs for the different options, which the Medicare Plan Finder makes simple. Moreover, you should verify each year that your preferred doctors, hospitals, and other health care providers are covered within your chosen plan. Medical insurance experts suggest that you call the office of your preferred physician or medical provider and ask to speak with the person at the front desk who files insurance claims. This person will be the most expert and reliable source to understand which Medicare Advantage plans are accepted.

5) You go it alone.

Whereas the Medicare Plan Finder may be an easy-to-use tool for many, that does not mean it is an easy-to-use tool for all. The reality is that many Medicare participants do not use computers or may struggle to effectively navigate the Plan Finder tool. Medicare can be a maze and it is wise to ask for help each year. We assist clients in the annual evaluation of Medicare plan choices and there are insurance agents who are more equipped that us to tackle this evaluation. Given the high costs of choosing an ill-fitting plan – either in dollars or in the inconvenience of learning later that your doctor is no longer covered by your Medicare Advantage plan – Medicare participants owe it to themselves to get help in this annual process.