SCHV - SCHV: Significant Downside Risk Ahead

2023-09-28 07:15:15 ET

Summary

• SCHV has a portfolio of large-cap value stocks in the United States.
• SCHV's portfolio of value stocks underperformed the broader economy in economic recessions.
• The fund's valuation is still towards the high end of its historical average, and there is significant downside risk in an economic recession.

ETF Overview

Schwab U.S. Large-Cap Value ETF (SCHV) owns a portfolio of about 500 U.S. large-cap value stocks. The fund has lagged the broader market in 2023, but its valuation is still towards the high end of its historical average. The fund has typically underperformed the S&P 500 index in the past, especially during the time of economic turmoil. Given that a recession is likely coming very soon due to the Federal Reserve's policy of keeping the rate elevated or higher and for longer, investors may want to patiently wait on the sidelines.

Fund Analysis

SCHV has been rangebound since mid-2022

Value stocks in general fared much better during last year's stock market correction. Although SCHV's portfolio of value stocks still suffered a decline of about 21% in the first 10 months of 2022, it was much better than the 33% decline of its growth peer Schwab U.S. Large-Cap Growth ETF ( SCHG ). However, the opposite was true in 2023 also. While the broader stock market has performed quite well in the first half of 2023, SCHV only recovered some of its losses. As can be seen from the chart below, its fund price has only improved modestly from the trough reached in October 2022. In fact, SCHV only gained about 8.6%. In contrast, SCHG delivered a return of 26.6% in the same period.

Valuation is still not cheap

Let us now examine SCHV's valuation. Below is a chart that shows the valuations of growth and value stocks in the S&P 500 index. While S&P 500 value stocks are not the same as stocks in SCHV's portfolio, there is significant overlap as both include large-cap value stocks. Therefore, it will still provide insightful information and will help us to gauge SCHV's valuation. As can be seen from the chart below, value stocks have an average forward P/E ratio of 16.4x. While this forward P/E ratio is significantly lower than growth stocks' 20.8x, it is still towards the high end of its own historical average. Therefore, we do not see SCHV as cheap at this price. Since value stocks generally have slower growth profiles than growth stocks, we do not think it is wise to buy SCHV at this valuation. Some margin of safety is desired.

Significant downside risk in an economic recession

Let us now examine its downside risk in times of turmoil. As can be seen from the chart below, SCHV has suffered significant decline in the initial outbreak of the pandemic in 2020. The decline was more significant than the broader market represented by the S&P 500. In fact, SCHV declined by more than 37%. In contrast, the S&P 500 index declined less, as shown by the blue line.

Ideally, it will be better to look at how SCHV has performed during the Great Recession. Unfortunately, the ETF's inception date was in 2009. Therefore, we do not have such information. Fortunately, its peer fund iShares Russell 1000 Value ETF (IWD), which also tracks U.S. large-cap value stocks, has this information. As can be seen from the chart above, IWD also suffered a much greater loss than the S&P 500 index during the Great Recession in 2008/2009. Therefore, we do not think SCHV offers better downside protection even during an economic recession.

We may be heading for a mild recession in H1 2024

So, the question many investors may want to ask now is whether we will be heading for a recession soon. Our base case is that there will be a recession coming likely in the first half of 2024. We believe the aggressive rate hike and the possibility of more rate hikes to combat persistent inflation may eventually derail the economy. The reason that it has yet to happen is because it generally takes a while for the effect of rate increase to propagate through the economy. While a soft-landing of the economy is possible, combating inflation may be a much more difficult task than one may have thought. This is because in a high inflationary environment, labours will demand higher wages. This will result in higher commodity and services prices. There is a spiral effect in place. Therefore, the path towards the Federal Reserve's long-term target of 2% inflation rate may take longer than the market may have anticipated. It will be too soon to expect that the Federal Reserve will soon lower the rate. Hence, investors should not ignore the risk of an economic recession.

In an economic recession, not only earnings of these value stocks will be impacted, valuations will also be compressed. As we have seen in an earlier graph about forward P/E ratios of value stocks, valuation compression is quite evident during the economic recession.

Investor Takeaway

We may be heading for a recession very soon. As we have discussed in our article, there is significant downside risk. Hence, we believe it may be wise for investors to wait on the sidelines.

Additional Disclosure : This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.

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