In the end, it all boils down to sentiment

Value investors know that the outperformance of cheap stocks over expensive stocks comes in lumps and is not smooth. One way to ‘time’ value stock outperformance is to look at the valuation spread between cheap and expensive stocks. But this spread is driven by sentiment and is itself a good predictor for most factor returns, not just value stock returns.

Value in the academic literature is commonly measured via price/book-ratios, rather than price/equity-ratios or other metrics. This is simply done because book value is much more stable than earnings, so most of the difference between cheap and expensive stocks is simply a reflection of the ‘value’ markets put on the book equity of a business.

The chart below shows the difference between the market equity (i.e. average share price per unit of book value) of cheap and expensive stocks in the US going back to 1926. Every investor who is familiar with market history and the returns of value investors can immediately see that when this difference was very high (e.g. in 1969 at the height of the Nifty Fifty bubble or in 2000 during the Dot.com bubble) value stocks outperformed in the years after. But when the difference was very low (e.g. 2008 after the Lehman collapse or in 2020 during the pandemic panic) value stocks underperformed expensive stocks for years.

The spread in market equity between expensive and cheap stocks in the US

Source: Zhang (2024)

A study by Shaojung Zhang from Ohio State University examined, how this difference in market equity relates to future outperformance of value stocks as well as other factor returns. Let me quickly summarise the main result. Just like previous research has found, the larger the market equity difference between cheap and expensive stocks is the higher the outperformance all kinds of factors are in the future, not just value.

The new study found that in the years after a large difference in market equity between cheap and expensive stocks, momentum strategies work better, and factors based on profitability measures or investment intensity work better as do factors that rely on market frictions like the outperformance of illiquid and small-cap stocks. The only factors that do not seem to work better when the difference in market equity is larger are factors driven by accounting rules like factors based on intangible asset intensity.

But if a large number of factors and styles tend to work at the same time, doesn’t that indicate that they are all more or less driven by the same underlying force? It seems so, especially when one looks at the correlation between the difference in market equity with investor sentiment and the cyclically adjusted PE-ratio (CAPE) of Robert Shiller.

Correlation between difference in market equity and investor sentiment (top) and CAPE (bottom)

Source: Zhang (2024)

The two charts above show two important things. First, the spread in market equity is correlated with swings in investor sentiment. When investors are particularly optimistic, the difference between cheap and expensive stocks is large but when they tend to be more rational or even pessimistic, the difference in market equity is small. This shows that differences in valuation between stocks are mostly driven by investor optimism. When investors are particularly optimistic, they bid the shares of certain companies into the sky while ignoring other companies. The result is that there is a broad-based divergence in valuation. Once overly optimistic sentiment normalises again, value stocks outperform as do companies with high quality, lower leverage, smaller companies out of the spotlight of investors, etc. As investors become more rational, all kinds of factors start to work.

The second important insight from the charts above is that the correlation between the spread in market equity and CAPE valuations is lower than the correlation between the spread in market equity and investor sentiment. In particular, in the last fifteen years or so since the financial crisis, the CAPE and the spread in market equity have increasingly diverged. Is it a surprise that CAPE has stopped working since about that time? Not if you ask me. The CAPE shows an expensive market, but what it ignores is that all stocks in the US are similarly expensive. There is little difference in valuation between the expensive and cheap stocks which means that there is little in terms of selective investor optimism driving valuations apart.

One may argue that the high level of the CAPE indicates that all stocks are expensive at the same time. But in this case, one has to wonder how value stocks should outperform against expensive stocks if all stocks are expensive.

I think for a whole host of reasons that the CAPE has stopped working and high CAPE values are no longer indicative of US stock market underperformance or outperformance of value stocks vs. expensive stocks. At least not as long as the difference in market equity between cheap and expensive stocks remains as low as it is today. And if you are a long-term value investor in the US, the low spread in market equity should worry you.