- With COVID-19 setting off an uncertainty bomb that is still rippling through markets, many market structures we are observing are at historic extremes.
- Interest rates may determine whether high market concentration reflects the sustainable winner-take-all dynamics of a digital and global economy, or a record breakdown of market diversity that will ultimately collapse.
- We maintain our discipline of investing in stocks trading well below our estimate of business value, with business model improvements being driven by internal or industry changes during COVID-19 and enough balance sheet strength to see price and value converge even if the crisis is extended.
Market Overview and Outlook
The real power of statistics has nothing to do with math. Its real power is that it provides a framework to change your mind based on data. The art of changing your mind is a critical part of thinking, but our human nature works against it. It is incredibly hard to escape the power of prevailing narratives that reflect existing beliefs and perceptions. Our tendency is to see what we want to see, and we seek out confirmatory data that facilitates this desire. The key then is to truly seek out diverse data, and to try and fully understand any opposing arguments.
In the spirit of practicing this critical art of thinking, this letter will explore some current market observations but discuss them from two entirely different perspectives. For simplicity, we will break the observing investors into two camps: the “extrapolators” and the “reversionists.”
The extrapolators carefully observe existing conditions and argue that most of the time the best way to predict the future is to look to the recent past. This approach is supported by the accumulation of data and observations that build up over a market cycle, which confirm prevailing trends and narratives. This mounting support creates powerful feedback loops, as capital flows follow rising market prices, which then attract more flows. This feedback loop has been an especially powerful dynamic over the recent market cycle, with ever more capital flowing into U.S. growth and momentum stocks. The strength of the extrapolation strategy is that it aligns investors with the game that is being played on the market field at the given time. The risk for extrapolators is that all games eventually end, as new winners and losers do emerge over time. These transitions are also often abrupt and painful for the extrapolating crowd.
The reversionists argue that all things cycle across a spectrum of extremes, with the arc of fear and greed defining the market cycle. When anything gets to extremes, the best way to predict the future is to assume things will ultimately converge with readings closer to historic averages. The strength of the reversion strategy is that major change is ultimately unavoidable. Accordingly, huge wealth can be made or preserved by betting against extremes by buying assets on the cheap before they reflect the realities of a new market cycle. The risk for reversionists is that cycles don’t follow some well-defined clock, and averages and ranges can change significantly over time. Our digital era may have materially altered historic distributions.
With COVID-19 (C19) setting off an uncertainty bomb that is still rippling through markets, one thing both camps can agree on is that many things we are observing are at historic extremes. These extremes mirror the reality that investors really don’t have a good map of the current market landscape, as the uncertainty of C19 is taking us into entirely new territory. It will take time for uncertainty to be transformed into risk markets can price, and this leaves ample room for debate. In the spirit of people seeing what they want to see, we will apply a Rorschach test of sorts to the two camps using some of the major charts in the gallery of current market extremes.
The first chart speaks for itself in showing the extreme and historic pain for the value style over this market cycle. As we write this, value relative to growth is falling to new lows for the cycle, and on many measures is approaching the cheapest levels relative to growth ever. Is this expected given the cyclical risks from C19, or is this a growth bubble that will pop?
Exhibit 1: Value Is at its Cheapest Relative to Growth Since Dot Com Bubble
- The Extrapolating Eye: The prevailing growth narrative is based on data. Value companies were getting disrupted before C19 from the digital transformation of the economy. In addition, slowing structural economic growth and deflationary pressures are huge headwinds for cyclical companies that dominate value sectors. The C19 shock and recession just accelerated and exacerbated these challenges. Many growth companies have enjoyed accelerating revenue growth from a physically locked-down world, while value companies experienced more direct pain. The widening fundamental chasm between value and growth justifies the growing valuation disparity.
- The Reverting Eye: Value was already historically cheap versus growth before C19 and in many cases already reflecting a recession. These even more extreme growth-value dispersions now hint at a bubble that could pop when a vaccine arrives or if policy continues to support a recovery. In addition, growth stocks are priced as if C19 never happened, but if C19 creates continued economic pressures growth companies will start to share in the cyclical pain as customers face bankruptcy and extinction. Thus, growth could be a loser in a recovery or another downturn, while value already discounts immense pain and no recovery.
The U.S. market is arguably the most concentrated ever, as assets continue to crowd into an increasingly narrow set of secular winners (Exhibit 2). Does this reflect the sustainable winner-take-all dynamics of a digital and global economy, or will a record level of crowding risk and diversity breakdown ultimately collapse?
Exhibit 2: Concentration of the S&P 500 in Top Five Constituents at All-time High
- Extrapolator: The FAAMG stocks (Facebook, Apple, Amazon.com, Microsoft and Google/Alphabet) are effectively global platforms with competitive moats that grow stronger over time through network effects and global scale. These advantages also accelerated due to C19, and the reality is that these stocks are not that expensive relative to their share of the global profit pool and their growing competitive advantages. Finally, many of these companies have evolved into digital staples that customers cannot do without in a digitally connected world and are effectively the most defensive stocks to own in an uncertain environment.
- Reversionist: These companies are effectively global monopolies with a rising regulatory risk of being broken up. In addition, earnings and cash flow growth for a few of these companies have stalled out and stock performance over the last few years, and certainly during C19, is being driven purely by investor flow-driven multiple expansion. Given enough time, all companies die as diseconomies of scale, new disruptors and other unexpected challenges mount. Any change with this level of index concentration and lack of diversification is an accident waiting to happen.
While the previous charts showed growth heaven, the next two show the depths and suffering of value purgatory (Exhibits 3 and 4). Relative performance for both commodities and financials is at multidecade lows and gaining speed as the descent continues. Does this mirror image of the current winners reflect the understandable result of a low-growth world drowning in excess capacity, or a historic collapse in investor expectations in the two classic deep value sectors that always precedes a major mean-reversion journey?
Exhibit 3: Relative to S&P 500, Commodities Nearly as Cheap as Ever
Exhibit 4: Banks Underperforming the Market by Widest Margin in Recent Memory
- Extrapolator: These two sectors have been the center of the storm since the Great Financial Crisis (GFC), and C19 and the OPEC oil market share war introduced even more pain. With leveraged balance sheets, excess supply of commodities and low interest rates, these two sectors own the left tail in any crisis. In addition, interest rates are likely to stay lower for longer, and ESG-focused capital prioritizing renewable energy is a massive headwind for commodities as even more capital will flee the sector and pressure long-term demand.
- Reversionist: After a record-breaking growth cycle, investors have forgotten how to invest in cyclicals. You buy them when there are bankruptcies - they sell well below replacement value - and when capital is fleeing the sector. Responding to the price chart, capital spending in commodities has collapsed to multidecade lows and the probability of a major supply-driven commodity cycle is building. For financials, they are being treated as if nothing has changed from the GFC, but balance sheets enjoy record liquidity and capital. The great market strategist Bob Farrell’s rules can be directly observed in these charts: markets mean revert over time and exponential moves are always corrected by an exponential move in the opposite direction. Finally, higher interest rates are now the real tail risk, and financials and energy are two sectors that are convex to and will benefit from that true tail risk. Long-duration growth stocks will get crushed if interest rates go higher.
One of the other historic extremes that we are observing is that market time is moving at a record pace. We had the fastest bear market in history, the fastest recovery in history, likely the shortest recession ever, and there have been ongoing market moves in single weeks that used to occur over five years or more. Thus, waiting for the truth to emerge in the extrapolator versus reversionist debate will likely not be measured in years. At a broad level, the debate will hinge on whether this conjunction of historic tail events results in a new market cycle, or rather extends the last one.
We think the determining macro variable will be interest rates. If rates stay low, the capital-driven feedback loop will drive U.S. growth stocks even higher, and they will enjoy a bubble that rivals the 2000 experience. If rates start to grind higher, however, we think it will signal a new market cycle and the beginning of a value cycle.
Unfortunately, forecasting rates is next to impossible. The data of the last cycle clearly supports the extrapolator argument of lower-for-longer interest rates. However, we have just had arguably the biggest policy shift in U.S. history, with fiscal spending well in excess of what we saw during World War II, and a monetary response that is monetizing the debt from the record fiscal spending. It is not surprising that inflation expectations are rising (Exhibit 5), and there is an underappreciated risk that inflation and rates could really accelerate once we get a working vaccine - or maybe not!
Exhibit 5: Inflation Expectations Have Spiked While the 10-Year Yield Has Plummeted
The question, of course, is how do you position a portfolio for an unknown event with a binary outcome? We have tried to position the portfolio across a broad spectrum of names from all market sectors with the specific goal of maintaining a very large active bet on value, with all its characteristic cyclical volatility, but offset by more stable stocks from traditional defensive sectors like health care, staples and utilities. During the quarter this objective was achieved by adding two consumer discretionary names, Melco Resorts and Six Flags Entertainment, and an industrials name, Sensata Technologies, all of which will benefit materially from a recovery. We also added a utility, DTE Energy, a stable consumer discretionary name, Sony, and a defense name, General Dynamics. In all cases, our investment process maintains its discipline of investing in stocks trading well below our estimate of business value, with business model improvements being driven by internal or industry changes during C19 and enough balance sheet strength to see price and value converge even if the C19 crisis is extended.
This truly diversified portfolio positioning allows us to embed the critical art of changing our minds. If a vaccine does get developed, we think a recovery can be sustained and growth and value can both do well as excess liquidity continues to inflate assets. What a recovery then means for rates will likely determine whether the recovery in value is just the tactical value trade we discussed in last quarter’s letter, or something bigger. As active valuation-disciplined managers, we will pivot accordingly based on what we observe and adjust the portfolio’s mix between defense and offense accordingly.
Despite a relative performance bounce during the second quarter, this has been a historically brutal period for value managers like us. It seems the only thing the massive policy response to C19 is not trying to bail out or save is value managers. Meanwhile, we are finding room to improve every day and are positioning the portfolio to take advantage of historic extremes that will eventually start to converge - perhaps much sooner than the crowd thinks. This historic opportunity is balanced by portfolio construction that is extremely diversified across holdings with the staying power to endure the aftershocks of the C19 uncertainty bomb. We will continue to ask the critical question of what would make us change our minds as we prepare for a time when a market at extremes changes its mind.
The ClearBridge All Cap Value Strategy had a positive return during the second quarter, outperforming the Strategy’s benchmark Russell 3000 Value Index.
On an absolute basis, the Strategy had gains in all 11 sectors in which it was invested during the quarter. The primary contributors to the Strategy’s performance were the financials and health care sectors. The utilities and real estate sectors were the main laggards.
In relative terms, the Strategy outperformed its benchmark primarily due to stock selection decisions during the quarter. Stock selection in the financials, consumer staples, health care and industrials sectors contributed the most to relative returns during the period. Conversely, stock selection in the energy, consumer discretionary and information technology (IT) sectors detracted. In allocation, an overweight to the energy sector helped relative results.
On an individual stock basis, the greatest contributors to absolute returns during the quarter were positions in Synchrony Financial, Covetrus, Sprouts Farmers Markets, AutoZone and Johnson & Johnson. Wells Fargo, Six Flags, Sanderson Farms, Service Corporation and Fairfax Financial were the largest detractors from absolute performance.
Besides portfolio activity mentioned above, during the quarter we closed positions in Alaska Air in the industrials sector, Pebblebrook Hotel in the real estate sector and Qualcomm in the IT sector.