March 6, 2023
Rockbridge Institutional – February 2023 Market Review
All stock markets were down In February no doubt reflecting the ongoing uncertainty of rising interest rates, inflation and an economic slowdown. With its 0.25% increase in its Federal Funds Target Rate, the Fed continues to signal its commitment to rein in inflation. While Consumer Price Index (CPI) increases are looking better recently, no one is declaring victory. How far the Fed will go with increasing rates and whether it will trigger a recession remains uncertain. Not only does this uncertainty impact stocks negatively, but also Increased interest rates reduce the present value of future cash flow and stock prices generally.
This ongoing uncertainty helps to explain losses in domestic large cap (S&P 500), small cap (Russell 2000) and international developed markets of about 2% this month. Emerging markets were off nearly 4%. After a pretty good January, these February results brought the quarter-to-date returns in a global stock portfolio to under 5%. While short-term stock returns are unpredictable, continued volatility remains a safe bet.
Yields for Treasuries maturing beyond a year, yields were up 0.05% in February pushing prices down. An index of 3-to-5-year Treasury securities was off 2% in February. An index of shorter maturing Treasures was off a little less than 0.1% while those maturing in 7-to-10 years were down over 3%.
While the future path of inflation is far from clear, market predictions over 5- and 10-year periods obtained from the spread between nominal and inflation adjusted yields has remained relatively constant at about 2.5%, which provides some comfort that inflation may be short-lived. We’ll see.
The Value Premium
After trading at significant discounts in recent years, over the most recent twelve months an index of domestic large cap value stocks traded at a premium of 8% to the S&P 500. These results prompt an examination of the persistence of value premiums.
Stocks are often divided into two categories – “growth” and “value”. Expected cash flows from growth stocks reflect future investment opportunities and a steeper trajectory, expected cash flow from value stocks, on the other hand, are from assets in place, and consequently the slope is flatter and more immediate. Growth stocks are distinguished by higher price to earnings (P/E) ratios, value stocks by lower PE’s and higher book to market ratios. Value investing goes back to 1934 with the publication of Benjamin Graham’s “Security Analysis – Warren Buffett is a disciple. Metrics that distinguish growth and value stocks are used to build indices and allow us to measure value premiums in past data.
Using indices published by Russell and MSCI we observe an average 1% premium in domestic small cap and international market indices. We don’t see an average premium in domestic large cap market in Russell indices. However, an annual average value premium that exceeds 2% with greater volatility is present using the so-called “pure value index” published by Standard & Poor’s. While there is evidence of a value premium over the long run, taking advantage means accepting volatility.