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Fears over the spreading coronavirus are causing stocks to roller-coaster. Some say the drops offer great buying opportunities. Others say U.S. stocks, in particular, are still priced far too high.

Economist Robert Shiller would agree with the pessimists. The Yale University professor and Nobel Laureate devised a strict way to measure the level of the overall market. It’s called a CAPE ratio (cyclically-adjusted price-to-earnings ratio). The CAPE ratio is more stringent than a traditional price-earnings (PE) ratio. It averages corporate earnings over a 10-year period and makes adjustments for inflation. This way, a single great business year or single bad year can’t make the market look artificially cheap or expensive.

When the CAPE ratio is far above its long-term average, it usually spells trouble for the decade ahead. Historically, U.S. stocks trade at a CAPE ratio of about 16.9 times earnings. But according to Shiller’s price index, the U.S. market’s CAPE ratio exceeds 26 times earnings (as of March 11), including the market’s recent plunge earlier this week.

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It has only been this high twice before: in 1929 and from 1997-2000. And the decades that followed were dismal for stocks. That doesn’t mean stocks will crash, but history says they have little room to run.

Larry Swedroe and Kevin Grogan’s book Reducing The Risk of Black Swans provides a range of expectations. Referencing CAPE ratio data from AQR Capital Management’s Cliff Asness, they found that when CAPE ratios exceeded 25 times earnings, U.S. stocks barely beat inflation over the decade that followed.

That doesn’t mean you should sell stocks and stuff money into bonds, gold or mattresses. Nobody can see the future. If you’re dollar-cost averaging into a diversified portfolio of low-cost ETFs, keep doing that. But if your portfolio includes mostly growth stocks, you might be partying on Everest’s summit without an oxygen tank or tent. After all, when stocks fall hard, it’s the highest-priced growth stocks that usually fall the furthest.

The popular FANMAG stocks – Facebook, Apple, Netflix, Microsoft, Amazon and Google – have defied gravity in a way that hasn’t been seen since the dot-com boom of the late 1990s. Seven years ago, if you split $10,000 between shares in these six stocks, your investment would have ballooned to about $97,381 by the beginning of March. That’s a whopping average return of 38.2 per cent per year compared to 16.5 per cent per year for the S&P 500.

Investors in a U.S. growth-stock ETF would have trounced the S&P 500 too. Measured in Canadian dollars, Vanguard’s U.S. Growth ETF (VUG) averaged almost 19 per cent annually over the same seven years.

Research Affiliates partners Rob Arnott, Campbell Harvey, Vitali Kalesnik and Juhani Linnainmaa say growth stocks have beaten value stocks over the past 12 years, but they haven’t done so entirely on the merits of their business earnings.

As a sector, their stock prices have risen far faster than their business profits. In their white paper, Reports of Value’s Death May Be Greatly Exaggerated, the researchers say the valuation gap between growth stocks and value stocks is near an all-time high. That means the growth-stock advantage might be ending soon and cost-conscious investors should consider value.

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That might be tough to believe, if you’ve seen how value stocks have lagged. For example, Vanguard’s U.S. Value Stock ETF (VTV) averaged about 14.64 per cent annually over the past seven years, measured in Canadian dollars. That’s almost 2 per cent per year lower than the S&P 500 and more than 4 per cent per year lower than a U.S. growth-stock index.

Canadian value stocks aren’t doing better. Over the past seven years, iShares Canadian Value Index ETF (XCV) averaged about 5.9 per cent per year. In contrast, iShares Canadian Growth Index ETF (XCG) averaged about 8.92 per cent per year.

But most of the time, value beats growth. When examining the past 83 rolling 10-year periods, U.S. value stocks beat growth stocks about 85 per cent of the time. And with market levels trading at nosebleed heights, value stocks might offer some refuge in a crash.

Between 1972 and 2019, U.S. stocks recorded seven calendar-year declines that exceeded drops of 7 per cent. Value stocks beat growth stocks during all seven of those years – and by an average of 9.19 per cent per year. The difference was most dramatic in 2000, when the CAPE ratio (as it does today) traded above 26 times earnings. Value stocks beat growth stocks that year by a whopping 28.3 per cent.

Value vs. growth when the markets fall hard

Calendar-year declines exceeding 7 per cent, 1972-2019

YearU.S. Large-Cap StocksLarge U.S. Value StocksLarge U.S. Growth StocksValue Stock Advantage
1973-16.18%-9.79%-23.09%13.30%
1974-26.93%-21.13%-32.34%11.21%
1977-7.84%-3.31%-8.66%5.35%
2000-9.06%6.09%-22.21%28.30%
2001-12.02%-11.86%-12.93%1.07%
2002-22.15%-20.88%-23.68%2.80%
2008-37.02%-35.97%-38.32%2.35%
Average advantage of value over growth9.19%

Factor-based funds, such as growth and value ETFs, charge higher fees than cap-weighted ETFs. But if you’re looking for a U.S. value stock ETF trading on the TSX, you might consider BMO’s MSCI USA Value ETF (ZVU). Its management expense ratio (MER) is 0.33 per cent. BMO’s MSCI Canada Value ETF (ZVC) tracks the Canadian value equity index. It charges an MER of 0.40 per cent.

Pickings are slim for an international value-stock ETF trading on the TSX. But the iShares Fundamental Index ETF (CIE) might fit the bill. It isn’t weighted based on market capitalization. Instead, its stocks are weighted based on their economic footprints. As a result, it doesn’t have high exposure to stocks with sky-high PE ratios, but with an MER of 0.72 per cent, this ETF isn’t cheap. Investors can find a lower-cost alternative on the New York Stock Exchange: the iShares MSCI EAFE Value ETF (EFV) charges an MER of just 0.39 per cent per year.

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Long-term, value stocks beat growth stocks. And they really trounce growth when stocks hit the skids. Growth investors might say, “This time it’s different.” But those are the four most dangerous words an investor can utter.

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