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The current market environment is witnessing a phenomenon that defies traditional historical patterns: a violent liquidation in momentum and software stocks occurring simultaneously with a broader market hovering near all-time highs. This decoupling suggests a profound shift in market leadership, moving away from the "growth at any cost" narrative toward fundamental value and real-economy assets.
In a recent discussion on The Compound and Friends, John Mowrey, Chief Investment Officer at NFJ Investment Group, dissected this volatility. Mowrey provided a masterclass on the evolution of value investing, the decay of traditional alpha factors, and why the current "slaughterhouse" in momentum stocks might be the healthiest development for the long-term bull market.
Key Takeaways
- Factor Decay in Value Investing: Traditional value metrics like low Price-to-Book and Price-to-Earnings lost their efficacy post-2008 due to the rise of passive ETFs, which commoditized these factors and turned alpha into beta.
- The AI Anti-Bubble: We are witnessing a unique market divergence where "AI winners" (hardware/infrastructure) remain strong, while "AI losers" (software companies being displaced by AI) are experiencing severe drawdowns.
- The "Tenure Trap": In a rapidly evolving financial landscape, decades of experience can sometimes be a liability if it anchors investors to market mechanics that no longer exist.
- Rotation into Real Assets: Capital is rotating out of digital momentum trades and into physical economy sectors—specifically Financials, Energy (refiners), and Materials—where earnings growth is supported by valuations.
- Crypto Correlation: Bitcoin and Ethereum have ceased to act as uncorrelated stores of value, instead trading in lockstep with speculative tech assets due to the introduction of ETFs.
The Evolution of Value: Overcoming Factor Decay
For decades, value investing was relatively straightforward: buy stocks with low price-to-earnings (P/E) ratios or low price-to-book values, and wait for mean reversion. However, Mowrey argues that the "golden age" of this simple approach ended around 2008. The subsequent years revealed a phenomenon known as factor decay.
How Passive Flows Commoditized Alpha
The proliferation of ETFs and smart beta products democratized access to specific investment factors. Strategies that previously generated alpha—excess returns above the benchmark—were packaged into low-cost funds available to everyone. When proprietary insights become universally accessible products, the premium associated with those factors evaporates.
"When the ETFs came out, it took diversified alpha and it made it beta. It no longer was alpha. So you couldn't just bias toward a factor and get the same alpha that you could have pre-that."
Furthermore, the exclusion of high-growth technology companies from value indices created a blind spot. By rigidly adhering to traditional definitions of "value," many managers missed the structural profitability of the last decade's dominant tech giants.
The Solution: Customized Peer Groups
To combat factor decay, modern value investing requires a more nuanced approach to valuation. Rather than using broad sector classifications (like the GICS sectors), investors should look at customized peer groups based on economic symbiosis.
For example, comparing a chemical company like Sherwin-Williams strictly to other chemical commodity producers is flawed. Sherwin-Williams trades at a premium because its business model aligns more closely with home improvement retailers like Home Depot. Similarly, comparing Union Pacific (rail) with Prologis (industrial real estate) offers better valuation context than traditional sector peers, as both are integral parts of the supply chain logistics network. Correctly identifying these peer groups is essential for determining true relative value.
The Momentum Stock Slaughterhouse
The market is currently experiencing a historic anomaly. Typically, when a massive sector like software—comprising a significant portion of market cap—crashes, it drags the entire index down. Yet, we are seeing the S&P 500 remain resilient while popular momentum stocks suffer 30% to 50% drawdowns.
The AI Disruption Cycle
This divergence is driven by an "anti-bubble" narrative. The market is aggressively re-rating companies based on their relationship with Artificial Intelligence. On one side, you have the infrastructure builders (semiconductors, data centers) receiving massive capital inflows. On the other side, you have the previous cycle's winners—SaaS (Software as a Service) companies—facing an existential threat.
Investors are realizing that AI might not just improve software; it might replace the need for certain seat-based software licenses entirely. This fear has led to indiscriminate selling in the software sector, creating a "shoot first, ask questions later" environment.
"The market is taking out a rifle and it's saying you're out... You're an AI destroyer. It's not a shotgun. It's you're dead."
While this feels chaotic, it represents a rational capital cycle. Money is leaving areas of perceived disruption and moving toward areas of scarcity and tangible earnings.
Rotation to the Real Economy
As investors flee the uncertainty of the software sector, they are not moving to cash; they are rotating into the "real economy." This rotation is characterized by a shift toward companies that deal in atoms rather than bits.
Financials and Energy
Mowrey highlights Financials and Energy as the prime beneficiaries of this rotation. Unlike Consumer Staples, which are often treated as defensive proxies but currently trade at historically high multiples with low growth, Financials and Energy offer a compelling combination of low valuations and high earnings growth.
- Financials: Regional banks and major financial institutions are benefiting from a steepening yield curve and solid fundamentals. Following the liquidity crisis of early 2023, the sector has stabilized and offers significant upside as the largest component of the value universe.
- Energy Refiners: Refining companies are currently growing earnings faster than many technology stocks. With "crack spreads" (profit margins on refining oil) remaining healthy, these companies are printing cash while trading at single-digit multiples.
The Problem with Consumer Staples
A trap for many investors during volatile periods is the rush into Consumer Staples (e.g., Walmart, Coca-Cola). While these companies are culturally perceived as "safe," the data suggests otherwise. Staples are currently trading at forward P/E ratios that rival technology stocks, yet they possess a fraction of the growth potential. Paying 25x earnings for a company growing at 3% is a risk to capital, regardless of how "defensive" the business model appears.
The Liability of Experience
One of the most provocative concepts discussed is the idea that tenure in the investment industry can sometimes work against a portfolio manager. In a world where information is commoditized and market structures shift rapidly (e.g., the bond-stock yield relationship flipping), relying on "how things used to work" can be disastrous.
Mowrey notes that during the post-2008 era, many veteran investors insisted that interest rates had to rise and that the tech multiple expansion was a bubble waiting to burst. They were "experts at an earlier version of the world." To succeed today, investors must balance experience with the flexibility to accept new paradigms, such as the dominance of intangible assets or the structural changes in inflation dynamics.
"There are certain people who are experts at an earlier version of the world and that's who's on TV every day."
Conclusion
The violent rotation currently occurring in the market is not a signal of an impending crash, but rather a healthy cleansing of excess. The market is moving away from speculative, profitless momentum stocks and toward companies with tangible earnings and defensible business models.
For investors, the path forward involves looking beyond the "Mag 7" and the decimated software sector. The opportunities lie in the unloved pockets of the market—banks, refiners, and materials—where the fundamentals are disconnected from the price. By abandoning rigid historical factors and embracing a dynamic view of value, investors can navigate the "slaughterhouse" and position themselves for the next leg of the cycle.
