Prospects are tenuous for sustained outperformance of value stocks on the whole. We recommend owning value stocks, but would not broadly overweight just yet. The ability of value to lead depends on the degree to which economic and earnings growth reaccelerate, and, in particular, on outperformance of sectors dominating the value indexes. The latter has been unusually important in this cycle of value underperformance. Overall, despite underperformance, value on the whole is not that cheap. The deepest value is concentrated in energy and financials, which must turn around for value to outperform on a sustained basis. We would focus on pockets of value across the entire portfolio rather than the value style within equities. Energy-related assets (particularly fresh capital put to work in private energy) and emerging markets equities offer the best value opportunities today.

Based on MSCI’s developed markets style indexes, over the decade ended 2015, value stocks had underperformed growth by just over 200 bps annualized, or a cumulative 33 percentage points, the widest gap over a ten-year horizon since the decade ended early 2000, when large-cap tech and telecom stocks were in a bubble and investors were questioning the validity of value investing. The value style of investing has been in its most extended rout on record, failing to see a meaningful period of outperformance against the broad market and growth for about a decade, and against momentum for about six years. Despite sustained underperformance, valuations are not yet at the sort of levels that historically have reliably seen sustained reversals. The P/B ratio of the MSCI World Value Index is in the 50th percentile of historical valuations in absolute terms and the 49th percentile relative to growth.

Historically, earnings of value stocks have tended to outpace growth stock earnings at inflection points in economic growth. In fact, relative earnings are at levels comparable to those experienced at the start of other cycles, suggesting a turnaround should be drawing near. However, performance cycles can lead, lag, or match earnings cycles, making this a highly uncertain indicator for outperformance.

Growth stocks, particularly high-quality growth stocks (also in momentum indexes at present), have been more appealing to investors in this lower-growth environment. When economic growth is slow, investors favor stocks that can produce higher rates of growth. Ned Davis Research evaluated this phenomenon in the US equity market by looking at the relationship between the sensitivity of economic sector returns and their measure of coincident economic indicators. They found that faster growth favors cyclical sectors like financials and energy that are heavily overweight in value indexes, while slower growth favors consumer discretionary, consumer staples, and technology shares, which are significantly overweight in growth indexes. If the economy remains on its modest growth trajectory, value may continue to lag. However, should oil prices keep increasing and/or global economic growth surprise to the upside, value earnings should improve and the style should gain traction.

Relative to growth, the vast majority of value’s underperformance can be explained by the degree to which financials and energy have lagged other sectors, particularly those that dominate the growth index. Performance attribution analyzing the importance of sectors in explaining the difference between developed markets growth and value returns since the end of 2006 (when the last cycle of value outperformance ended) reveals that 85% of the performance differential was explained by economic sectors, with financials accounting for over half of the sector contribution. A similar analysis by asset manager AJO reveals that 75% of US value’s underperformance relative to growth since the global financial crisis was explained by differences in sector performance, in stark contrast to only 10% attribution for the 30 years prior.

This strongly suggests that financials in particular, but also energy, will need to take leadership away from consumer staples, consumer discretionary, technology, and health care before a firm reversal in the cycle can take place. It is unclear what will improve prospects for financials, which are challenged by low policy rates and have been seeking to redefine their business models under increased pressure on net interest margins with a shifting regulatory landscape. Own value, but it is too early to overweight value equities broadly.

Celia Dallas is Cambridge Associates’ Chief Investment Strategist.

For more discussion on value cycles, please see our research brief from October 2015, “Value Strategies Down, Not Out.”