A colleague clearly believing I have my own ‘How bad does this Value cycle feel relative to previous Value cycles’ swingometer often asks, “Does it feel like 1999 yet?” That is a pretty extreme benchmark he uses, and I thought that having survived that particular onslaught one of the positives was that it would be a once in a working lifetime experience. I was wrong. And yes, it does now feel like 1999. And the charts back up this view. For example, Morgan Stanley illustrates that, using a blend of three valuation metrics, European Value is as cheap relative to the market as it has been for many decades.
Figure 1: Undervaluation of Value vs Growth
Source: MSCI, Morgan Stanley Research
Despite – or because of? – this, August was another terrible month for value stocks globally with bond proxies outperforming and rising ever higher, while stocks negatively correlated to bonds (cyclical sectors such as industrials, financials, and consumer discretionary) underperformed and fell. Investor confidence in a looming recession and consequent ‘Japanification’ of the western world reached extreme levels. You can get a bit punch-drunk by these charts, as they’ve been delivering the same message for months now (if not years). However, the current ‘bond-bifurcation of equity markets’ as Soc Gen put it in a recent report is at unprecedented levels in terms of both relative performance and valuations (shown below for the US and Europe, based on median forward PE based on quintiles in MSCI US and Europe respectively.
Figure 2: US sector-neutral portfolios on bond correlation
Figure 3: Europe sector-neutral portfolios on bond correlation
Source: SG Cross Asset Research/Equity Quant
Several stocks are now shouting ‘recession!’ while, perversely, others – trading at very high levels relative to history – are perceived as completely immune to a recession, or indeed any negative outcome.
How has it come to this? I think we have a combination of at least three factors turbo-charging the growth/value trade:
Firstly, a belief that we are in a winner takes all environment and that certain companies are immune from cyclical or competitive pressures and will thrive in the future regardless of, well, anything.
Secondly, a growing belief that interest rates will remain low for much, much longer and therefore that the profits of the winners can be discounted at very low interest rates.
Thirdly, a memory of the depth of the recession in the Global Financial Crisis. Given the GFC is the only experience a high percentage of money managers have of a recession and a bear market, experience may influence their actions much more than prior recessions.
It is worth remembering that the GFC was extreme. Authorities were simply not ready for the implosion of the banking sector and it took them some time to formulate a plan. An apparent consequence of this severe experience for investors is that many managers sit in the ‘show-me’ camp. They wish to see some meaningful price momentum and more importantly earnings momentum before they buy into those stocks most vulnerable to a recession.
While this desire to wait is completely understandable, it suggests there is a large amount of money awaiting the same catalyst. But when that catalyst arrives, and this money looks for a new home, the identity of the sellers of cheap value stocks is unclear. The bounce-back could be sharp and severe. Admittedly, our call to arms is diluted as:
We’ve highlighted previously the relative cheapness of value to growth at higher levels.
We can give no indication on when the trend will reverse.
Understandably, the confidence of those who believe value is dead (again) has soared and the misery of the value investing clan is back to 1999 levels. However, markets have a dreadful habit of making the consensus look stupid at the point of peak comfort.
The value of investments, and any income generated from them, can fall as well as rise.
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All rights reserved. Issued by Investec Asset Management, issued October 2019.
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