An In-Depth Look at Factor Valuation - And Which Factors Look Cheap Today

Episode Summary

Executive Summary: The episode examines how to value major investing factors—value, momentum, quality, and low volatility—using both absolute and relative measures. The hosts stress that factor valuations are useful for understanding long-term expected returns and market structure, but are poor tools for short-term timing. The deeper lesson is to look beyond the numbers and understand the market forces causing each factor to look cheap or expensive.

Main Topics: Absolute vs. relative factor valuation (Priority: 5/5): The hosts explain the difference between judging a factor against its own history versus comparing it to its opposite factor (e.g., value vs. growth). They note both lenses can be informative, but neither should be used for short-term forecasting. Methodology for factor ranking (Priority: 5/5): They describe their process: define each factor, rank an investable universe of roughly 2,800 liquid stocks, take the top or bottom 20% depending on the factor, and use the median valuation of that group to track cheapness or expensiveness over time. Value stocks look cheap relative to growth but mixed on an absolute basis (Priority: 5/5): Value appears cheap versus growth across measures, but its absolute valuation varies by metric. Earnings recovery has made value look cheaper on PE, while high margins and profitability make price-to-sales look expensive. Momentum as a changing basket, not a fixed style (Priority: 4/5): Momentum is described as a chameleon because it has no fundamental anchor and can rapidly shift from growth stocks to value stocks. This makes it look cheap or expensive depending largely on what names currently have the strongest price trends. Quality becoming more attractive on a relative basis (Priority: 4/5): Quality is expensive absolutely because the broad market is expensive, but it has become cheaper relative to low-quality stocks that led much of the post-2020 rally. The hosts see more high-quality companies appearing in cheap value screens. Low volatility remains expensive (Priority: 4/5): Low-volatility stocks were already expensive after years of strong performance and stayed expensive through the pandemic. Even after some correction, they remain unattractive both versus their own history and versus high-volatility stocks. The real value is understanding market behavior, not timing (Priority: 5/5): The hosts emphasize that factor valuation data is best used to interpret what is happening beneath the surface of the market and what kinds of stocks are being rewarded, rather than to make tactical trades.

Key Arguments: Factor valuation can be evaluated in two ways: against a factor’s own history (absolute) or versus the opposite factor such as growth (relative). Absolute and relative valuations are useful for understanding expected long-term returns, but they are unreliable for predicting next-year performance. The valuation of a factor depends heavily on how it is defined and which metric is used; PE, price-to-sales, price-to-book, and forward or CAPE measures can lead to different conclusions. Value looks cheap relative to growth almost regardless of metric, but on an absolute basis it is mixed because earnings have improved while sales-based valuations remain rich. Momentum is unusually cheap because it currently contains many value stocks rather than the growth stocks it held earlier in the cycle; this shift reflects price trends, not fundamentals. Quality has become cheaper relative to low quality as speculative and lower-quality stocks have driven parts of the market rally. Low volatility is still expensive because it had a strong multi-year run and has not fully cheapened despite a recent decline. The most useful takeaway is not a trading signal, but insight into what market leadership says about fundamentals and investor behavior.

Data Points: Investable universe size: about 2,800 stocks - Approximate liquid stock universe ranked for factor definitions and valuation tracking. Factor basket size: top 20% / bottom 20% - Cheapest 20% are used for value; most expensive 20% are used for growth or the inverse factor. Historical valuation window: 2006 to present - The hosts reference percentile rankings and historical comparisons from 2006 onward. Value PE in March of this year: 15 - Trailing 12-month PE for the all-stock value universe in March was above its long-term average. Current value PE: 10.8 - Median trailing PE of the lowest 20% value stocks is now below the historical average. Low-volatility performance period: past decade - Low-volatility stocks had done very well over the prior decade, contributing to their expensive starting point. Factor timing evidence: mixed / not robust - The hosts reference research showing mixed evidence on using value to time factors, citing AQR and Research Affiliates.

Pivotal Quotes: "You don't want to be using relative or absolute valuation or spreads to make short-term market timing or forecasting calls because those things are impossible to predict." — Jack: He cautions listeners against interpreting factor valuations as short-term timing tools. "Momentum is a factor that has absolutely nothing to do with fundamentals. And so, what that allows it to do is it allows it to change very rapidly." — Jack: He explains why momentum can appear cheap or expensive depending on which stocks currently have momentum. "The biggest value here is understanding what's going on behind the scenes versus any sort of implementable investment strategy." — Justin: He frames the main takeaway as market interpretation rather than tactical action.

Implications: Investors should use factor valuations as a diagnostic tool for market leadership and long-term return expectations, not as a short-term trading signal. The key is to understand why a factor looks cheap or expensive and what that says about underlying market trends.