- Despite COVID-19-related economic weakness, ultimately there will be a very big tactical move in favor of value strategies as policy and time win the battle over the virus.
- The nature of value cycles requires the discipline and temperament to stick with value when it is at its most painful moments.
- Even after the recent compression in valuation spreads, from current levels the forward 12-month relative performance opportunity in favor of value is significant.
Most Lose Confidence in Value at Exactly the Wrong Time
The COVID-19 crisis will almost certainly be one of the most dramatic events we will experience in our lives, if not the most dramatic. Despite its terrible nature, new market cycles always emerge from the pain and fear of downturns. However, in the early stages of this downturn, pre-existing market trends in favor of growth and against value accelerated. Value as a broad category has been suffering mightily since 2017 (Exhibit 1), but this suffering accelerated into a value collapse in March that was arguably the worst period for value on record. However, as the battle between policy and the virus ensued, value started to bottom and fight back (Exhibit 2). The key question is how to dimension the potential for a value cycle?
Exhibit 1: Value Stocks Have Suffered Since 2017
Exhibit 2: Value Vs. Growth Trend Accelerated
To measure value cycles, we have long used the following valuation spread chart from Empirical Research Partners (Exhibit 3). The chart tracks the cheapest 20% of the market over time. When the line is rising, value is underperforming materially, but it sets up major opportunities for value outperformance when the spread compresses. Value cycles are violent in nature, characterized by sharp peaks and reversals. The nature of value cycles requires the discipline and temperament to stick with value when it is at its most painful moments. As valuation spreads rise, the math becomes easier while the emotional stress intensifies. Therefore, most people understandably lose confidence in value and value managers at exactly the wrong time, and this behavioral response is ironically one of the critical ingredients powering a value cycle.
Exhibit 3: Valuation Spreads Peaked at Third-Highest Ever
Valuation spreads peaked in mid-March at their third-highest level ever and have recently compressed to just over three standard deviations. Even after the recent compression in valuation spreads, from current levels the forward 12-month relative performance opportunity in favor of value has averaged almost 30% historically.
However, if there is one clear message here, it is that we are dealing with a scale of events — virus outbreak, economic slowdown, market selling, policy response — that we have never witnessed. With a virus able to spread exponentially on one hand and unprecedented policy response on the other, the range of possible outcomes is incredibly wide. With such ongoing uncertainty we cannot be sure that the equity market has truly bottomed and that valuation spreads will not widen again before a new market cycle begins. Especially with so much economic pain and dislocation headed our way.
What we do know is that ultimately there will be a very big tactical move in favor of value strategies like ours as policy and time win the battle over the virus. There is also the distinct possibility that the next cycle could favor value strategically if the historic merging of fiscal and monetary policy at an unprecedented scale gives birth to a higher level of inflation (although stagflation is a possibility). To be clear, as we navigate this deflationary collapse in the economy, there is zero evidence of inflation, and technology and demographics will continue to be structurally deflationary. However, given the emerging policy response and the reversal of globalization as a major deflationary force, there is potential for a major change in economic and market dynamics. For now, our goal is to survive this cycle in order to take full advantage of a tactical value cycle, while gauging if the current uncertainty gives rise to a longer-lasting opportunity for value down the road.