Much Ado About Value

Last week, we highlighted that the growth vs value spread has recently hit a high point since 2005, which led us to dive deeper into what might be causing this trend. We used the J.P. Morgan iDex U.S. Growth Index and J.P. Morgan iDex U.S. Value Index, which are much purer representations of growth and value than standard style indices, and found that the beta profile of these investment styles has changed significantly over the past year. We also found that the levels of idiosyncratic risk in these areas may indicate a possible growth vs. value rotation or, maybe even more importantly, that the time has come again for high stock picking opportunities in the value space.

Last week’s posting left many of our readers wondering, “what can we do about value?”. This week, we provide some insights to help answer this question.

Opportunity 1: Passive Investment in the Value Factor

Assuming a possible value trade opportunity, will the right play be factor-driven or idiosyncratic? In other words, will this be a good time for passive investing, or active value investing, or both? To find out, we try to look at similar times in history to help guide the answer.

In last week’s research, we identified that the trends driving the current value & growth market environment looks similar to trends we last saw during the Global Financial Crisis (GFC). In particular, we featured the chart below, which shows that the Market Sensitivity factor exposure (using the Axioma US 4 Medium Horizon risk model) within value recently hit the highest level since the GFC (purple).

Factor correlations implied from the risk model underscore a similar insight. The correlations between the Value and Market Sensitivity factors in 2020 are at levels not seen since the GFC.

Given this, the 2008-2010 period may provide a blueprint for what may happen in value over the coming months.

To evaluate our questions, we’ll start by creating a long-short spread portfolio to represent value as a systematic factor. The portfolio was constructed using the constituents and weights of the top and bottom ranked securities of the J.P. Morgan iDex U.S. Value Index (for more details on the methodology of this index, please see last week’s Factor Spotlight). When combining both top (long) and bottom (short) sides into a single portfolio, the result is a market-neutral spread portfolio (“Value Spread Portfolio”).

We used the Value Spread Portfolio to look back to the GFC to understand the performance behavior of value during that time. The chart below shows the cumulative performance alongside the Market Sensitivity exposure of the Value Spread Portfolio from January 2008 to June 2010. This allows us to understand whether the Market Sensitivity exposure levels within the Value Spread Portfolio act as an indicator for systematic value performance.

We see that Market Sensitivity exposure (purple) starts to rise around the time that the market was rallying going into the Lehman bankruptcy in mid-2008. The exposure rises, with some fluctuation, and hits a peak in May 2009, before subsequently falling sharply through the end of 2009 and into early 2010. The performance (blue) of the Value Spread Portfolio follows a similar pattern, rising from July 2008 through May 2009, with various fluctuations as the market reacted to the Lehman bankruptcy and ensuing government bailout packages. The market was able to squeeze out a bit more performance in value from May 2009 through Sept 2009, but by the time Market Sensitivity was already on the way down, the value performance started to taper off and did not move much in either direction by mid 2010.

Here, we’re using the Value Spread Portfolio as a proxy for value’s systematic performance and we see that the pure value play happens before the peak in Market Sensitivity exposure. In other words, if we used the peak in this exposure as an indicator for when to passively invest in value, we would have missed the boat. This leads us to believe that there isn’t a strong value factor trade as the Market Sensitivity exposure reverts.

Opportunity 2: Stock Picking In Value Stocks

Perhaps there isn’t a pure passive value opportunity as the Market Sensitivity exposure starts to normalize. However, just because the pure value play is limited doesn’t mean there aren’t other opportunities for value coming up. In fact, we know anecdotally that the post-GFC period was one of the best in recent history for skilled stock pickers in the value space. It’s possible that we may be coming upon another stellar time for active investing within value.

To examine this, we observe the levels of idiosyncratic risk in the value universe as a proxy for stock picking opportunity. Generally, when idiosyncratic risk is higher, this signals a good time for active investors because there are less systematic headwinds getting in the way of the fundamental opportunities of the stocks. A skilled active manager will be better rewarded for successfully picking stocks based on fundamental convictions when idiosyncratic risk is high and factor risk is low.

Using this intuition as a guideline, we calculated the median idiosyncratic risk of the securities on the long side of the Value Spread Portfolio. We repeated this calculation daily for the same period as prior: January 2008 to June 2010.

We see that idiosyncratic risk of this universe declines in the value universe going into the GFC, which is expected because correlations rise and factor effects tend to dominate in crisis periods. However, by mid-2009, idiosyncratic risk is on the rise and by the end of 2009, we were almost back at pre-GFC levels of idiosyncratic risk, as highlighted in chart above. This indicator started to fall by early 2010, indicating the high idiosyncratic risk was somewhat short-lived. Despite this, the elevated levels of idiosyncratic risk, or conversely, the low levels of factor risk, align with the notion of improved active stock picking opportunity during this time.

Looking at the same chart from 2019 to 2020 shows yet another parallel between the GFC and now.

Again, we see a major drop in idiosyncratic risk during the COVID downturn in March 2020, as correlations rose and factor risk took over. These levels bottomed out around June 2020 as the market started to readjust to the new normal and since then, idiosyncratic risk for the value universe has been on the rise. While we haven’t yet hit pre-COVID levels, this trend is very similar to what we saw coming out of the GFC.

We don’t know what the future holds for value investing, but the analysis above certainly leaves us feeling that we may see another period similar to post-GFC when there was significant opportunity for active value investing. Value’s stock picking heyday may be on the horizon!

Next week we have a special year-end treat in store where we unveil a countdown of our most popular and widely read Factor Spotlight issues of 2020. Stay tuned and wishing you all a great coming week!

US & Global Market Summary

US Market: 12/07/20 - 12/11/20

• The market drifted lower towards the end of the week, as congress remained gridlocked on a COVID-19 stimulus deal while infections and deaths from the virus across the US continued at a record pace.
• Companies with the highest exposure to the pandemic, including airlines, cruise lines, and consumer discretionary took a hit at the end of the week, dulling some of the effects of the November rally.
• December has seen a pickup in the IPO market, with Airbnb leading the charge (shares doubled on their first trading day). Pandemic favorite Doordash also hit a $60B valuation on its first day of trade.
• The UK became the first western country to administer a coronavirus vaccine (Pfizer’s), while Canada and the FDA both approved the vaccine for use this week.
• In the midst of the fiscal stimulus stalemate, Congress passed a one-week stopgap funding bill on Friday to avoid a government shutdown.

‍Normalized Factor Returns: Axioma US Equity Risk Model (AXUS4-MH)

• After hitting a recent bottom of -2.48 standard deviations below the mean on 12/7, Momentum appears to be on a recovery path after crashing in early November.
• After exiting Oversold space at the end of last week, Growth continued to recover from a recent trough of -1.28 SD below the mean on 11/25.
• Volatility saw a slight positive move as it headed higher into Overbought territory, now sitting at +1.61 SD above the mean.
• Value experienced weakness on a normalized basis as it drifted lower, still in Overbought space at +1.28 SD above the mean.
• Earnings Yield was the biggest loser on the week as it trended deeper into Oversold territory, now at -1.22 SD .
• US Total Risk (using the Russell 3000 as proxy) declined by 38bps.

‍Normalized Factor Returns: Axioma Worldwide Equity Risk Model (AXWW4-MH)

• Similar to the US, Momentum saw a recovery from a recent trough of -2.69 SD below the mean on 11/25 as it headed back towards the mean.
• Growth has started to revert towards the mean after a brief foray into Extremely Oversold space at the end of November (bottoming out at -2.02 SD below the mean on 11/27).
• Value continued to rise higher into Overbought territory, albeit at a much slower pace than last week.
• Size continued to decline, falling by -0.24 SD while retaining its Overbought label at +1.25 SD above the mean.
• Earnings Yield was the biggest faller as it declined by -0.33 standard deviations, landing at -0.63 SD below the mean.
• Mirroring the US, Global Risk (using the ACWI as proxy) decreased by 38bps.

Regards,
Alyx