Tuesday , November 19 2019
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The Bursting Bubble Of “B.S.”

Summary:
On the surface, middle of the road performance for stocks in the quarter indicated relative calm. Especially coming off strong performance in the first half of the year, there was little cause for concern. Performance was choppy in the quarter, however, as steady, modest gains were repeatedly undermined by significant losses. In addition, a quant quake came out of nowhere and led to massive outperformance of value over growth for a short period of time. Also, out of nowhere overnight repo rates spiked higher until the Fed intervened. Gold prices rose steadily. Under the surface, something seems to be amiss. What is that something and what does it mean for investors? For a growing number of investors, the answer is a short one: Stocks have overshot their fundamentals and a market crash

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On the surface, middle of the road performance for stocks in the quarter indicated relative calm. Especially coming off strong performance in the first half of the year, there was little cause for concern.

Performance was choppy in the quarter, however, as steady, modest gains were repeatedly undermined by significant losses. In addition, a quant quake came out of nowhere and led to massive outperformance of value over growth for a short period of time. Also, out of nowhere overnight repo rates spiked higher until the Fed intervened. Gold prices rose steadily. Under the surface, something seems to be amiss. What is that something and what does it mean for investors?

For a growing number of investors, the answer is a short one: Stocks have overshot their fundamentals and a market crash is imminent. Such concerns are serious partly because they come from some highly respected players and partly because if true, there would be serious consequences for investors. However, stocks have been highly valued for a long time and for the past ten years bumps in the road have always been smoothed over by central banks. Is anything different this time?

It helps to establish some perspective. One of the more prominent themes over the last ten years has been the outperformance of growth stocks relative to value stocks. Rick Friedman of GMO points out that “Over the past 12 years … value stocks have underperformed”. 

John Pease, Friedman’s colleague at GMO adds, “All in all, it has been a harrowing decade for those who have sought cheap stocks.”

The Bursting Bubble Of “B.S.”

This recent underperformance of value provides a notable break from its historical pattern. Friedman continues:

“Historically, buying companies with low price multiples has delivered substantially better returns than the overall market, with the added benefit of lower absolute volatility. From the inception of the Russell 3000 Value index through 2006, value stocks outperformed the broad market in the U.S. by 1.1% per year starting in 1978.”

Dan Rasmussen, founder and portfolio manager of Verdad Capital Management, described just how unusual this performance has been in the September 20, 2019 edition of Grant’s Interest Rate Observer:

“What has been abnormal … is the remarkable performance of growth stocks. That has really been driven by the very largecap tech companies, which have had this amazing combination of high growth, high profitability, high and sustained growth, high and sustained profitability (and starting to actually dividend out money). That historically is very, very anomalous. You don’t typically see the largest stocks grow the fastest.”

Indeed, Friedman explains that the reason value stocks tend to outperform is because they offer an attractive tradeoff:

“While value companies did in fact under-grow the market, their cheaper valuations, higher yields, and a number of other factors more than made up for their weaker fundamentals.”

The “engine of returns behind value portfolios is ‘the replacement process, whereby a formerly disappointing company sees its fortunes change and its prices respond (à la General Electric in the 80s).’

Investors systematically underestimate the ability of weaker and distressed companies to mean revert to profitability and reasonable growth levels. Instead, they overpay for growth by extrapolating relatively strong growth too far into the future.” notes Friedman.

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