2023-03-09 10:23:05 ET
Summary
- The Vanguard Value ETF should be expected to underperform U.S. Treasuries by as much as 4% annually over the next decade based on the current price-to-sales ratio.
- Rising UST yields could result in a 50% decline in VTV over the next few years relative to USTs, as has happened following several previous negative equity risk premium periods.
- It is hard to imagine a soft landing for U.S. value stocks, as the Fed keeps upside pressure on interest rates despite an impending recession.
Slowing growth and high bond yields have undermined the outlook for U.S. value stocks. While they remain cheap relative to the broader market, when measured relative to 10-year bond yields, U.S. value stocks are extremely expensive. It is hard to imagine a soft landing for U.S. value stocks as the Fed keeps upside pressure on interest rates despite an impending recession. The Vanguard Value ETF ( VTV ) is likely to generate returns of little more than zero over the long term and could easily see a 50% decline over the next 12 months relative to U.S. Treasuries.
The VTV ETF
Vanguard Value ETF tracks the CRSP US Large Cap Value Index. The index selects stocks from the top 85% of market capitalization based on multiple value factors. To determine value, VTV's index uses P/B, forward P/E, historic P/E, dividend-to-price and sales-to-price ratios. Following their recent outperformance financials stocks have the highest weighting in the ETF at 20%, followed by Health Care at 19% and industrials at 14%. Consumer staples make up another 11% while energy makes up 8%. The low weighting of technology stocks, at just 7%, in part explains the VTV's outperformance relative to the S&P500 over the past year. Berkshire Hathaway is the largest single stock on the index with a weighting of 3.1%. The dividend yield currently sits at 2.5%, while the expense ratio is just 0.04%.
Negative Equity Risk Premium And Weak Growth Make A Crash Likely
U.S. value stocks remain near their most expensive valuations on record on the basis of price-to-sales, which has been a much more reliable metric for forecasting returns compared to price-to-sales due to the mean reverting nature of profit margins. On this measure, the U.S. Value Index should be expected to return around zero percent per year over the next decade.
When we compare expected U.S. value returns to current 10-year bond yields, this measure of the equity risk premium stands at -4%, which is even lower than the level seen at the 2000 peak. This should not be considered as a bearish forecast, but merely the returns investors should expect based on history.
Bloomberg, Author's calculations
I have written extensively about the fact that bond yields and equity valuations show no correlation in historical data despite the theoretical boost that a lower discount rate has on the present value of future cash flows and vice versa. The reason being that periods of high interest rates reflect expectations of strong growth. As we saw in the late-1990s, U.S. equity valuations continued to rise in the face of high and rising bond yields as investors expected strong economic growth. However, bond yields are high and rising even as the real and nominal GDP outlook is rapidly deteriorating. As I have argued in recent articles (see ' Zero Percent Long-Term Growth Is A Real Possibility '), nominal GDP growth over the coming years is set to average significantly below current 10-year yields.
These are the conditions that make market crashes likely. The value index has lost half of its value relative to bonds on three separate occasions since 2000, each following periods when the equity risk premium on the above chart was negative as it is today. The value index actually underperformed 10-year bonds from 2000 to 2010 by a staggering 12% per year, as nominal GDP growth averaged a full 2pp below 10-years bond yields, causing sales growth to slow and valuations to contract.
Summary
There is no value left in U.S. value stocks in the context of high and rising bond yields, which have compressed the equity risk premium back to near its lowest level on record. Upside pressure on bond yields is coming despite deteriorating growth prospects, conditions that have often resulted in major declines in value stocks, particularly relative to bonds. The Vanguard Value ETF should be expected to underperform U.S. Treasuries by as much as 4% annually over the next decade based on the current price-to-sales ratio, and I would avoid this Vanguard Value ETF unless we see a sharp drop in valuations.
For further details see:
VTV: No Value Left In Value Stocks