Evaluating Expensive Markets Through a Factor Lens

Matt Stucky is the chief portfolio manager at Northwestern Mutual Wealth Management Company.

With markets continuing to test all-time highs, a key concern we hear from investors pertains to the valuation multiples the market is currently trading at and what that means in terms of how they should be positioned. To best answer this, we first need to understand why the market is becoming more expensive. Are we seeing valuation expansion across the board, or are a handful of stocks, sectors or factors responsible for higher multiples? This is something we can evaluate using a sector-neutralized valuation spread analysis, a method that helps compare the spread of similar investments by isolating certain factors and “neutralizing” sector weights.

Let’s use it to compare one of the most widely used valuation metrics: a blended 12-month forward price-to-earnings (P/E) ratio. What we find is that the basket of higher P/E stocks have become increasingly more expensive over the last two decades, with COVID-19 setting the apex for valuations, while the basket of lower P/E stocks has continued to trade within a tight range. As a result, the valuation spread—calculated by the weighted average P/E of top quartile (value stocks) minus the weighted average P/E of bottom quartile (expensive stocks)—has widened substantially.

As the valuation spread shows, the more expensive segment of the market currently trades more than one standard deviation above its historical average versus its cheaper counterparts. The reason for the higher spread is that investors are increasingly paying up to purchase companies believed to be leaders of the latest AI revolution, with key AI adopters and enablers setting themselves apart from the rest of the competition. In-demand companies are being bid up on higher top-line growth expectations as well as stronger earnings potential from AI-driven efficiencies. The result has been a heavy rotation into the information technology and communication sectors, which (combined) represent 43 percent of the S&P 500 market cap—up from 24 percent a decade ago. Valuation concerns often take a back seat as investors chase momentum and innovation, which can potentially lead to overpaying for stocks when investors’ bullish expectations fail to meet reality.

As fears of bubble-like valuations loom over Wall Street, the Northwestern Mutual Wealth Management Company is remaining balanced. Here’s how.

Quality, Momentum, Valuation: Our three-part approach for steady returns

As a refresher, our process first applies a quality filter to our investment universe (the S&P 500) to eliminate any companies that lack a sustainable competitive business advantage, hold excessive debt, or fail to outearn their cost of capital on a consistent basis. The remaining securities are then ranked by our sector-specific, multifactor quant model, which narrows down our selection for the final step of our process: a bottoms-up fundamental analysis. While our fundamental analysis dictates which stocks make it into our final strategies, let’s examine our in-house proprietary quant model, the foundational tool that helps narrow down our investment research. This model combines three uncorrelated (or even negatively correlated) factor buckets that have shown to be indicative of stock outperformance: quality, valuation and momentum.

With valuation being one of the primary pillars of our quant model, we prioritize stocks that trade cheaper relative to their sector peers. Quality may offset that a bit, given that it tends to trade at a modest premium to the market. Momentum, on the other hand, can fluctuate between cheap and expensive, depending on what is currently exhibiting return leadership in the market. A key benefit of our investment approach is its fluidity. The weekly rebalancing of our model gives us an immense amount of data at our fingertips to analyze, while a Bloomberg reconstruction of our exact model factors and parameters allows us to gather additional data beyond our inception date, 2016. This allows us to gain a deeper understanding of the valuation spreads between what our model considers attractive and unattractive investments.

How do we gather that data?

After constructing our sector-specific quant model in Bloomberg (excluding utilities and real estate with sector weights prorated higher to account for the excluded sectors), we then isolate the security selection by each factor bucket: valuation, quality and momentum. Next, we construct equal-weighted top quartile and bottom quartile portfolios based on those factor composites. From there we compare the valuation spread between the top quartile and bottom quartile portfolios using several valuation metrics: best P/E multiple, best price-to-sales (P/S) multiple and best enterprise value-to-earnings before interest, taxes, depreciation, and amortization (EV/EBITDA) multiple. By standardizing and equal-weighting these valuation spreads, we can then get a sense of how far above or below they are tracking relative to their 20-year average.

Valuation

For the valuation factor bucket, we would expect spreads to almost always be negative (Q1-Q4) given that the factors that populate this strategy are directly linked to owning cheaper stocks versus their expensive counterparts. We’re interested in evaluating the magnitude of the spread—in other words, whether the difference between cheap and expensive securities is larger or smaller than normal. Given the strong historical performance of valuation factors, value is also the highest-weighted bucket across every sector in our multifactor model. As a result, we should see favorable valuation spreads when we look at our full quant model (more on that later).

As shown in the charts above, all current valuation spreads are trading below their historical averages, with the standardized valuation spread 1.3 standard deviations below the mean. This tells us that value stocks (quartile 1) are currently trading at a significant discount to their more expensive counterparts (quartile 4) than historic levels. Discounts of this magnitude are quite rare, and we have not seen levels like this since the COVID pandemic recovery. From the trough standardized spread in August 2021, the top quartile portfolio (cheap) outperformed the bottom quartile portfolio (expensive) by 21.5 percent over the following 12 months and by 48 percent over the following three years.

Quality

Higher-quality stocks tend to trade at a premium, as investors pay up for superior growth, strategic competitive advantages, stronger balance sheets and higher profitability. Therefore, we would expect the valuation spreads within this factor bucket to skew positive (Q1-Q4) over the long term. This spread analysis is critical given our bias to own high-quality stocks at attractive valuations. Any spread compression here would be an indicator for an opportunity to buy quality at a discount.

As expected, quality tends to skew more expensive, as illustrated by the positive valuation spreads shown above. However, there have been rare instances in which quality has traded at steep discounts, primarily coming out of the Great Financial Crisis and the COVID pandemic. This is unsurprising given that lower quality/junk stocks tend to perform well coming out of a recession as investors expect the economy to recover quickly. As you often hear us say, these junk rallies are relatively short-lived—hence our commitment to owning high-quality stocks over a long-term time horizon.

We urge investors to take note of valuation spreads when these junk rallies occur. They might just be a rare moment to purchase high-quality stocks at an attractive discount. Following the trough spread that occurred during COVID, the top quartile portfolio (quality) outperformed the bottom quartile portfolio (junk) by 4 percent over the following 12 months and by 28 percent over three years. Currently, quality looks to be trading fairly in line with its mean given the standardized spread, meaning that it is neither cheap nor expensive on a historic basis.

Momentum

As mentioned earlier, momentum—traditionally defined by stocks’ total return—can favor both value and growth depending on the market environment. Valuation spreads typically fluctuate as the market transitions between each strategy. However, because we blend total return momentum with business momentum, defined by revisions of company fundamentals (revenue, earnings, etc.), the valuation spreads shown here may lean more expensive given that strong fundamentals are a sign of higher quality.

Sure enough, we see momentum stocks trading at a premium over the long term and presently as the AI frenzy generates outstanding total returns and upward revisions to company fundamentals. On the other hand, the momentum factor is prone to experience higher levels of volatility around periods of inflection in the economic cycle. This is why you may see spreads widen later in the cycle as the market grows more concentrated in segments perceived to be less economically sensitive. We usually then see a sharp reversal heading out of recessions as investors begin purchasing more cyclical and lower-quality stocks. This regime change is the worst-case scenario for a momentum trade and has historically delivered significant performance drawdowns. Despite higher volatility, it remains a key element in our quant model because it has proven to be an indicator of long-term outperformance and is consistently negatively correlated to our largest factor weight, valuation.

Full Model

The true value of our model is unlocked when we blend all three factors—valuation, quality and momentum—together. By combining these uncorrelated factors indicative of long-term outperformance, we expect to identify high-quality stocks with powerful momentum, strong performance and attractive valuations. Let’s take a look at the same spread analysis we did for each underlying factor composite to understand if our model is directing us toward a more value-oriented basket of stocks or a more expensive one.

The Northwestern Mutual way: A balanced approach for long-term results

By balancing valuation, quality and momentum, our long-term strategy has been shown to drive exceptional outperformance since the inception of our investment process in 2016. Through bull and bear markets, high and low inflation, fluctuating interest rates and even a pandemic–turned–recession, our model has remained resilient. Our blend of low/negative correlated factors is built to drive long-term stock outperformance even if one factor is lagging. By capturing the robust performance of quality and momentum in the current market, our model is helping offset underperformance in the valuation bucket. Does that mean valuations are irrelevant, and investors should prioritize only growth and momentum? Not so fast. A valuation discipline helps to reduce the likelihood of overpaying for stocks while also diversifying away the unique drawdown risk of the momentum factor.

As valuations increasingly move higher across the capitalization-weighted market, we remain true to our investment thesis: owning high-quality companies with ongoing business momentum at attractive valuations.

The opinions expressed are those of Northwestern Mutual as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. No investment strategy can guarantee a profit or protect against loss. Past performance is no guarantee of future results. This material does not constitute investment advice and is not intended as an endorsement of any investment or security. Information and opinions are derived from proprietary and non-proprietary sources. To learn more, click here.

There are a number of risks with investing in the market; if you want to learn more about them and other investment-related terminology and disclosures, click here.