Getting Ready to Embrace Value

In this market, it's a good idea to have a roving eye.
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When times are good and people are feeling flush, do they shop for cheap clothes? No? Then why would they want to buy cheap stocks? (I am making the presumption that there is no such thing as a dumb question.)

The persistent divergence in returns between growth and value investment styles has been maddening to many, among them active managers, investment consultants, pension-plan sponsors, financial planners, mutual fund investors and finance professors. Growth has bested value steadily for almost six years, according to

Russell 1000

indices. This is long enough in market years to seem like an eternity, and the scale of the performance divergence has reached historic dimensions. The relentlessness of the growth outperformance may by now have lulled some investors into taking it as an entitlement.

But fully half of this excess return of growth over value, believe it or not, has come in the last 12 months. Consider, from March 1993 to March 1998, using Russell 1000 monthly data, the growth index compounded at 20.0% annually while the value index returned 18.1%. That's a much smaller spread than I guessed before checking the numbers. This annual difference compounds to nearly a 20%


total return gap, which is significant, but hardly a show-stopper. With that as a base, however, the past 12 months' 24% deviation between these two indexes opens up the six-year performance gap to 80%, or 217% cumulatively for Russell 1000 Growth vs. 137% for Russell 1000 Value.

The persistence of growth's outperformance, and its cumulative magnitude, has made it possible to perceive the death of value. (Bargain hunting? We're so prosperous now that we can't be bothered to bend down to pick up $20 bills.) But by decomposing the time pattern of these relative returns over the past six years, it is possible to see the trend deviation in relative performance as a five-year creep topped by a one-year crescendo. And with that perspective, it is possible to posit the resurrection of value.

The distinguishing characteristic of the past 12 months was the global financial panic of 1998's third quarter. Surely you have not forgotten that the world economy was said to be on its way to extinction last fall? With meltdown into deflationary depression then a respectable, if not the prevailing, view, it was nearly impossible to make a case for the established cyclical industries that make up an important segment of the value universe. And so a panicky market heaped return on the same "reliable" growth names that had worked relatively well in the prior five years of slow global growth and rapid technological innovation.

But in recent weeks, a different tone has developed. Value has outperformed growth. Cyclicals have shown some life. International equities, as an asset class, have bested U.S. domestics. The

Wall Street Journal

last week ran a pungent headline, "Apocalypse? No!," on a front-page column that examined the idea that global financial crisis has bottomed out. The deflationary depression market call is no longer respectable. And the prospects for real global economic growth now are such that "growth" is no longer so surely in short supply.

A broader global participation in economic expansion should mean improvement in earnings for many more industries than has been the case in the past year, and so the market is likely to broaden out. Given the creep-and-then-crescendo pattern of the growth outperformance since 1993, many depressed value names are now at historic deep discounts to their more favored growth competitors. Even a partial catch-up could make for a dramatic relative performance shift.

"Apocalypse No!" implies global warming. Japan's equity market continues to levitate above its fiscal year-end closing level, so maybe its 1999 performance -- up 21% on the headline

Nikkei 225

and 63% on the domestically oriented over-the-counter index -- is due to something other than official price keeping operations. Maybe that market is beginning to take seriously the restructuring and stimulus initiatives of the past year. Spreads on emerging-market bonds have begun to show meaningful shrinkage, and former pariahs -- Korea, Brazil, and even Russia -- have been able to access global credit lines, either private or official. The price of oil, still the ultimate commodity, has moved farther and lasted longer than anyone had expected: West Texas intermediate crude has moved from $11.62 to $17.33 in nearly a straight line over the past two months. Wall Street numbers-crunchers are falling all over themselves to mark up their earnings estimates while attempting to expunge any record of their loss of faith last fall.

Did I read it right? Is the


really going to activate thousands of military reservists to support Kosovo operations? The private business sector might envy that ability to summon trained workers on demand; the unemployment rate, at 4.2%, hasn't been this low since the

Vietnam War

years. Some of those reservists must have day jobs in such places as corporate IT department where they are not likely to be easily spared. Warfare drains resources from civilian uses. (European unemployment rates are nearly triple that of the United States, so maybe¿ Yeah, right.)

Pressure on resources may ease the pricing constraints on several of the deep cyclical industries that have been operating at low levels of capacity utilization. That's good news when considered from the viewpoint of the relative recovery of value. It implies a broadening out of the market, an improvement in what has become perilously narrow market breadth. But it might not be great news from the point of view of influential members of the

Federal Open Market Committee

. Governor

Laurence Meyer

last week made the pressures of the labor market a centerpiece of his analysis of the issue facing monetary policymakers. "The question that has to be confronted is whether such an accommodating policy remains appropriate, going forward, especially once the unemployment rate has declined to the low end or below the low end of the range of estimates of NAIRU" -- the

nonaccelerating inflation rate of unemployment

. If growth remains robust and labor markets stay tight, and if inflation does not continue at the same time to move lower, it is his view that it would then be appropriate to link the Fed funds rate to changes in labor force utilization, i.e. to the unemployment rate.

The U.S. Treasury bond market is stuck in a range, drawn to the sterling inflation numbers, repelled by strong growth, and nailed in place by the perceived fixity of the Fed funds rate. And the greatest of these is the market's perception of Fed policy. If that starts to change, then bonds are likely to break out of their Hamlet-like indecision.

Put it all together and you get, as ever, an indeterminate result. Better growth, stronger earnings, a broader market, participation by value names that are now at historic discounts to the pampered few that have driven the indexes to record highs - it's quite an exciting prospect.

But still tighter labor markets, Balkans uncertainties of many sorts, persistence in oil price elevation, recovery in other parts of the world and therefore an improvement in their relative attractiveness to global capital, the possibility of a reversal of Federal Reserve permissiveness - that's quite an exciting prospect, too.

It is early days still, and maybe too soon to jilt the faithful performers of recent years. But having a roving eye, while bad for interpersonal relations, makes a world of sense in this market.

Jim Griffin is the chief strategist at Aeltus Investment Management in Hartford, Conn. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. Aeltus manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. While Griffin cannot provide investment advice or recommendations, he invites you to comment on his column at