Gauging the Potential for a Value Cycle

Gauging the Potential for a Value Cycle

Growth and value stock trends suggest there's potential for a major change in economic and market dynamics.


Key Takeaways

 

  • Despite COVID-19-related economic weakness, ultimately there could 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

As of April 11, 2020. Source: ClearBridge Investments, Bloomberg. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Exhibit 2: Value Vs. Growth Trend Accelerated

As of April 11, 2020. Source: ClearBridge Investments, Bloomberg. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

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

As of April 1, 2020. Source: National Bureau of Economic Research, Empirical Research Partners Analysis. Measures U.S. large cap valuation spreads, top quintile compared to the average. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

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 could 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.


Definitions:

COVID-19 is the World Health Organization's official designation of the current novel coronavirus disease.

Deflation refers to a persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money.

Growth refers to stocks of companies whose earnings are expected to grow at an above-average rate relative to the market. A growth stock usually does not pay a dividend, as the company would prefer to reinvest retained earnings in capital.

Stagflation refers to a situation where inflation is high, economic growth slows down, and unemployment remains steadily high. The term is used to invoke the policy dilemma that actions designed to lower inflation may exacerbate unemployment, and vice versa.

Standard deviation is a measure of the dispersion of a set of data from its mean or average.

The valuation spread is calculated comparing trailing price/earnings (P/E) ratios of the cheapest 20% of the market to the market average over time.

Value refers to an investment approach that aims to select stocks that trade for less than their intrinsic values.

Top

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is approved for distribution in those countries and to those recipients listed below. Note: this material may not be available in all regions listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Qualified Investors in Switzerland:
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.  Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All investors in the UK:
In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People's Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC's commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC's commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia and New Zealand:

This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827).  The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.