Another False Dawn or the Start of a New Regime?

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Over the last few years there have been many false dawns in the battle between value investing and growth investing and consequently, I think many investors have given up on the idea that there will ever be a sustainable rotation from growth to value that persists for an extended period. I now frequently read growth managers commenting in their quarterly letters to the effect that ‘value may have a bit of a bounce, but it won’t last’. I have never completely understood how they are able to make these predictions with such confidence.

It has to be said, however, that as rotations go, this week’s move has been a big one which does make one wonder if something more significant is happening. As Jonathan Stubbs, strategist at Berenberg, commented:

“European banks and energy had their best day relative to technology and healthcare for over 25 years. In the US, momentum strategies endured their worst day since 2009. US and European ytd laggards rallied by an average of 20%+ in a single session. Such moves suggest the swift unwind of crowded trades and fast-track pressure for investors to rebalance portfolios”[1]

The following charts also give some idea of how extreme the rotation was:

Source: Bloomberg, 12th November 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

Source: Bloomberg, 12th November 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

Finally, these are some of the biggest movers in our fund following the Pfizer vaccine announcement.

Price Move from 11:44 on 9th November (1 Minute Before Pfizer’s Vaccine Announcement) to Close 12th November

Capita PLC 50%
Marks & Spencer Group PLC 22.9%
BT Group PLC 20.8%
Barclays PLC 17.8%
BP PLC 17.5%
TOTAL SE 14.9%
NatWest Group PLC 14.3%
Royal Dutch Shell PLC 14.1%
Standard Chartered PLC 12.9%
Dixons Carphone PLC 11.2%

Source: Bloomberg, November 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. The names shown above are for illustrative purposes only and is not intended to be, and should not be interpreted as, recommendations or advice.

Whilst we cannot say definitively that these moves are going to continue, we can make the following observations about what might have caused them.

  • The gap in valuations between value and growth was at record levels, even bigger than that which existed in March 2000 at the peak of the dotcom boom.

Source: Morgan Stanley, 30th October 2020.

  • Market positioning was very lopsided and as the chart below shows, many investors have crowded into the most popular stocks such as US Technology/FANMAG. The UK market feels eerily reminiscent of 1999 to me with value fund managers suffering record redemptions whilst money pours into growth funds where managers are being rewarded for holding stocks at record high valuations. Whilst chasing performance has historically been a poor strategy, investors seem to have convinced themselves that this time is different. Many fund managers with a feeling for self-preservation have given up looking at valuation and there has been an incredible style drift towards growth investing amongst those who might have previously described themselves as ‘core’ or ‘style neutral’. It is, of course, worth mentioning that the five years following 1999 were some of the greatest for value investors.

Source: BoA Global Fund Manager Survey, 30th October 2020.

  • Liquidity is poor. I still think investors underestimate the ease with which blocks of money can be moved around the market even in some of the FTSE 100 stocks. Since the market crash in March, while there has been an increase in market volumes, market liquidity has deteriorated. Market depth (the market’s ability to sustain relatively large market orders without impacting the price of the security) remains significantly lower than pre-Covid-19 levels. Top of Book Liquidity for the FTSE 100 and EuroStoxx 600 is trading 32% and 30% lower respectively than the January average. This is coupled with bid/ask spreads that have remained wider than their pre-Covid-19 average.

Top of Book Liquidity represented by the median number of shares proxied against January average (split by market)

Source: Liquidnet Investment Analytics, 30th October 2020.

These three conditions created a very unstable situation and that is why we have seen such a violent move, the analogy being the turbulence that is created when passengers crowd on to one side of a boat and then simultaneously rush to the other side. These three conditions have not gone away despite the moves this week and that is why it is possible that they may continue.

Rotation between styles used to be the norm, particularly at key macro turning points.

Ignoring the fact that growth managers have a large incentive to state that ‘value investing will never work again’, I think a bit of recency bias is creeping in for those who predict that the rotation cannot last. The reality is that the last few years in which one investment style has dominated returns to such a significant extent is a very rare occurrence. Historically, markets have tended to move from one regime to another and the turning points were often associated with key macro events (some of which are listed in the table below).

Event Result
1992 - Britain exits the ERM Decline in GBP and decline in interest rates starts economic recovery that favours cyclicals
1998 - Asian debt crisis Cyclical stocks underperform, defensives hold up well
2000 - Interest rates increase following false Y2K worries TMT rolls over, old economy stocks start five years of outperformance
2003 – Interest rates are cut in the US Cyclical rally through to 2008, real estate boom
2009 – Central bank intervention post GFC Sharp rebound in in cyclicals and financials
2010-11 – Eurozone crisis Defensives outperform cyclicals and financials
2012 – Mario Draghi ‘whatever it takes’ speech Recovery from eurozone crisis, financial and cyclicals outperform
2015 – China slowdown Commodity rout, energy and mining stocks do badly
2016 – China recovery Rebound in commodity stocks

Source: RWC Partners, 19th November 2020 .

If half the world’s economy shutting down to combat coronavirus was a key macro event, then history would suggest that coming out of this phase will lead to a regime change. Or do investors really believe that some stocks can beat the market regardless of the stage of the economic cycle?

So where does that leave us now?

As none of us (not even growth managers) have crystal balls, we cannot say for certain that this the start of a new regime but there are certain things that seem possible to me and yet markets appear to be pricing them as very low probability events.

  • There was already a recovery coming through and it must be possible that this continues in to 2021, especially if we are able to end the policies of rolling lockdowns of the economy.

Source: Bloomberg, 30th October 2020.

  • The vaccine will reduce the chance of measures which have damaged the economy this year being repeated. Most governments are now aware of the massive economic damage that has been done by repeated lockdowns and I do not think they are keen to repeat them. The news on the vaccine thus offers them a potential exit route from the policy of rolling lockdowns.
  • Both monetary and fiscal stimulus measures are still enormous. The Bank of England have just announced a further £150bn of quantitative easing bringing the total to nearly £900bn. Meanwhile the Federal Reserve are on course to expand their balance sheet from $4 to $9tn this year which is very significant when compared with the fact that it took them ten years post the Global Financial Crisis (GFC) to go from $1to $4tn. Most other central banks are pursuing similar policies which collectively amounts to a huge dose of monetary stimulus.

Source: Bloomberg, 30th October 2020.

  • It is also worth pointing out that in contrast to 2009, this money is not going exclusively into financial markets because it is being used to finance governments deficit spending which means that in part, it is ending up in the real economy. The US government is likely to run a $4tn deficit this year which compares with $1.4tn post GFC. In the UK we look likely to run a £350bn deficit for the year which will take debt through £2tn. For the moment the bond vigilantes have gone missing in action and hence governments, believing they have found the magic money tree, show no sign of stopping this spending. Conversely it seems likely that support during the Covid-19 crisis will rapidly morph into funding pet projects whether that is universal basic income, Green New Deal or white elephant infrastructure projects such as HS2. In summary, fiscal stimulus is set to remain very significant.
  • Cyclicals stocks are still very undervalued as the chart below demonstrates. Investors are currently being offered banks on less than half their book value, energy companies on close to double digit dividend yield (on already cut dividends) and retailers on 5x our estimate of their long run earnings power.

Source: Morgan Stanley, 30th October 2020

2021 could, therefore, see an economic recovery from very depressed levels in which the sectors that do the best are cyclicals and financials whilst those that lag are defensives (healthcare, consumer staples, technology). If this is the case, many investors are currently tilted in the wrong direction to benefit from that. The chart below gives an indication of which sectors are likely to perform in this environment; at the very least, I would want to begin to hedge against this scenario by reducing my exposure to growth and increasing value.

No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. Source: Refinitiv, 9th November 2020.

This might have been ‘the catalyst’ that so many investors have been waiting for?

It has been frustrating talking to investors in the last six months who agree with us that valuations for certain sectors are at rock bottom levels but who want to wait for ‘the catalyst’ before making their move. I personally don’t agree with that approach as I believe that when you are being offered the possibility of a large return in a stock you take it and don’t worry about hitting the very bottom. I am not, however, in the position of an asset allocator whose clients have very short time horizons and therefore I understand why some are worried about being too early. There are, however, several risks to this approach; firstly, you need to be confident in your ability to identify the catalyst either in advance or even with hindsight. This is not as easy as it sounds. Was the vaccine announcement last week the catalyst or was it the trough in March? Our typical value fund is 8% ahead of the market over the last six months, so maybe the trough was in the first quarter of this year and we have all missed the catalyst.

Secondly, even if you are able to identify the catalyst, maybe others can too and if everyone tries to re-allocate at the same time, prices are going to move substantially. This would seem to suggest that the more prudent course of action would be to gradually start to reposition in advance of an event which, if you are honest, is very difficult to predict.

Are these moves a warning about the dangers of the ‘one bet’ portfolio?

For some time now, bonds and growth stocks have moved in the same direction and this is fantastic when both are going up. One of the points of diversification, however, is to try to have sets of assets which are non-correlated such that a gain in one will offset losses in another. Owning bonds plus bond like equities does not achieve that objective as the chart below demonstrates.

Source: SG Cross Asset Research/Equity Quant, Factset.

As the yield curve begins to steepen (chart below), investors may like to consider whether their current mix of assets give true diversification or whether they need to increase their exposure to value equities in order to achieve this.

Source: Bloomberg, 12th November 2020.

Conclusion

We don’t know for sure whether this is yet another false dawn or the start of a regime change but we can surmise that the severity of the moves were the result of record wide dispersion in valuations between growth and value stocks, lopsided market positioning and illiquid markets. At the very least this should serve as a warning about lack of diversification (100% growth, 0% value) or poor diversification (mixing bonds and bond like equities). With an economic recovery looking more likely in 2021, it is possible that some investors need to start to consider increasing their exposure to value stocks.

In my 30year career as a fund manager, there have been two occasions in which a market dislocation has created an opportunity for investors to potentially make very attractive returns and I believe we are now witnessing a third. The first was in 2000 when investors became convinced that the future was in technology, media and telecommunication (TMT)  stocks and sold nearly everything outside of these sectors thus creating a starting valuation in so called ‘old economy stocks’ that virtually guaranteed attractive future returns (the price earnings ratios and dividend yields of sectors such as tobacco and utilities actually crossed over). The second occasion was in 2009 post the GFC when a belief that the world’s financial system was under threat of collapse caused investors to sell not just those sectors most at risk but anything remotely cyclical in nature. In that year, high quality companies like Next plc became available at 5x their trough earnings (a 20% earnings yield). It is important to note that these opportunities look obvious in hindsight, but at the time they required a contrarian mindset and a determination to look at the facts rather than yield to a powerful narrative created by many market participants. The opportunity being presented today could actually be greater than the previous two because the dispersion in valuations is wider now than it was in 2000 and 2009. Investors may come to regret missing out on these gains because of their desire to hit the exact bottom.

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