Shift from momentum to value stocks may be a bet on rising rates

A sudden shift from momentum stocks to value plays could mean investors are betting on higher interest rates.

This week there’s been a dramatic rotation from the high valuation stocks that have driven the market’s run-up to more steady companies with lower valuations.

Bespoke Investment Group compared two exchange traded funds by MSCI, the Momentum factor ETF and the Value factor ETF, to illustrate the trend.

According to these ETFs, momentum stocks are up 2.8% this week, while value stocks are down 3.5%, a very large diversion for such a short amount of time.

The spread between these two funds tracks yields on the 10-year Treasury reasonably well, as seen in the chart below, but this week it has broken away.

The breakout, which follows a recent uptick in bond yields, means one of two things, said Bespoke analyst George Pearkes.

“Either equities are over-reacting to the recent move higher in rates, or they’re predicting a more extended turn higher in yields,” he wrote.

Bond yields continued rising on Tuesday with the 2-year at 1.654% and the 10-year up to 1.697%.

The improvement in yields comes even as the Federal Reserve is widely expected to lower its key rate when it meets later this month. It also stands in contrast to what central banks around the globe have been doing: lowering rates into negative integers and increasing quantitative easing operations to fend off a global economic downturn.

It’s perhaps counter-intuitive that the market would be expecting these higher yields to last for long in a global interest rate environment that includes nearly $17 trillion in negative yielding debt.

The Momentum ETF used in this comparison invests large- and mid-capitalization stocks that have enjoyed big moves in valuation. It’s top five holdings are Visa Inc., Mastercard Inc., Microsoft Corp., Procter & Gamble Co. and Walt Disney.

The Value ETF, buys U.S. large- and mid-capitalization stocks with relatively lower valuations. It holds AT&T Corp. Intel Corp., IBM, Pfizer Inc. and Bank of America in in its top five.

Beyond signaling a bet on interest rates, a repositioning from momentum to value could indicate a flight to safety for investors concerned about a downturn, even as the market hovers around new highs.

“If interest rates are done falling and about to turn higher, it hurts high growth stocks with sky-high P/E ratios by diminishing the future value of earnings and raising borrowing costs,” Pearkes said.