For stock pickers, especially those with a systematic approach, it has been a very difficult time. The constant change in sentiment is creating a great deal of uncertainty. It is challenging to find stocks that are expected to perform well in a given market environment when the market environment is so uncertain because it is changing more rapidly and unexpectedly. Are rates going up or down? Are tariffs going up or are we coming to an agreement with China? Is the bull market going to end or keep grinding on? Will we see negative bond yields? Is there a recession looming? Can value stocks ever outperform again? Laying the Twitter updates on top of what is already a unique environment puts investors in an unprecedented spot.
In a transcribed audio blog available through Bloomberg, Cameron Crise sums up the situation very well: “Ordinarily, it’s not that difficult to look through short term developments and focus on the value proposition of longer-term fundamentals. But these days the noise threatens to become the signal, and that’s a difficult environment for most investors to operate in.”
Having a behavioral mentality, the current inefficacy of value is reminiscent of a concept from social psychology called the “fundamental attribution error”. This was a concept that Lee Ross & Richard Nisbett wrote about in The Person and the Situation. In it, they claim it relates to “people’s inflated belief in the importance of personality traits and dispositions, together with their failure to recognize the importance of situational factors in affecting behavior.” In short, if we were to predict how someone might behave, it is better to understand the situational context, than to know any individual character traits.
Personifying this to the factor environment, it is analogous to the fact that many companies that rank well on specific factors (character traits), are underperforming due to extraordinary market (situational) dynamics. This is particularly true for companies that screen well on value. There is a tendency to over-attribute to the value factor and give less credence to the market forces that create a situation where value does not work well. The future returns to value are dependent not on how value stocks performed in the past, but how investors perceive their outlooks, based on interpretation of the current situation.
With respect to the question of the performance of value, here we chart the weekly, and rolling 52-week returns to value, measured by the spread between decile one and ten of our cash-flow-to-price model. The chart shows how the last few years have not been kind. The rolling 52-week return recently made new lows, dropping below the previous bottoms made in 2017/early 2018. In fact, since the end of the financial crisis, three of the five worst weekly returns occurred in 2019, with the week ending August 9th the most negative. Managers of systematic strategies that incorporate value are having their mettle tested. Us included.
Source: S&P Global; 361 Capital. Russell 1000 screened for various price, liquidity, and analyst coverage characteristics.
Those that follow a systematic approach know there will be times when the strategy lags but stick with it knowing there is an expectation of outperformance over the long-term. During periods of underperformance, it is easy to just chalk it up to “this is one of those periods and it will reverse”. The difference between [name your factor] not working and the market environment creating a situation where it does not work sounds like splitting hairs, but it is an important difference, one of perspective. Again, equating this to social psychology, the authors provided an example where both the observers and the actors in an experiment had to explain why the actors behaved as they did in that experiment. The observers attributed the actors’ actions more to their individual attributes – specific personality traits – whereas, the actors themselves attributed their own actions to the situational aspects – responding to the environment.
I think this would be like concluding that value is broken because of its current underperformance, instead of looking at the bigger picture where the macro environment is creating a situation that is bad for value strategies. It is somewhat of a nuance, but subtle differences can have significance and help frame our thinking of when value will make a comeback. It is not so much a function of mean reversion in-and-of itself, but of when the macro environment becomes more conducive.
Read our recent blog post, Alternatives Could Capitalize on Passive Equity Risk >