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Economy  | July 16, 2020

I’m bearish on the stock market on an absolute valuation basis relative to economic fundamentals amid the COVID pandemic. More pointedly, I believe rising volatility in momentum and value investing strategies may be signaling a shift in investor perceptions of the stock market.

Investors who have enjoyed strong returns and are feeling optimistic should at minimum, today, identify the primary source of their strong performance and make sure the factors that have lately supported their portfolios will persist going forward. I believe this is especially true for investors who are riding expensive stocks with strong price momentum.

While I try to avoid timing the short-term direction of the market or the short term direction of a given investment strategy and tend to think long-term, I do believe stock investors today should be very cautious. I myself have reduced my stock market exposure substantially in the past several months, and I wouldn't be surprised by a meaningful shift in investor attitudes in the coming months.

I base my assessment on recent spikes in volatility of returns to investment strategies based on value and momentum. While the sample size is tiny and I am mostly eyeballing charts, I think there’s intuitively appealing evidence that the market is primed for a shakeup.

Bubble Echoes In Quantland

In a recent appearance on the Acquirers Podcast, AQR co-founder, quant strategy pioneer and avid Tweeter Clifford Asness said that today’s investment environment is not an exact replication of the dotcom bubble peak, but it does “rhyme.” I want to focus on two of his observations:

  • The value factor, which quant strategies exploit by buying stocks that are cheap relative to fundamentals (price, cash flow, book value, or something proximate) and shorting expensive ones, has been in an abysmal drawdown for the past decade. The drawdown is worse than I think many investors realize – it surprised me.
  • The momentum factor, which quant strategies exploit (I’m simplifying here) by buying stocks that have been going up and shorting stocks that have been going down, has been performing well. Asness calls momentum “your only friend in a bubble.”

If buying cheap stocks and selling expensive ones is a long-run successful strategy, then the current pain for value strategies is not sustainable. If value returns to historical form, expensive stocks should underperform relative to cheap ones. Such a reversal of fortunes would leave many of today’s stock investors wrong-footed. This return to form for value is an anchor of my bearish thesis on stocks.

(Quick note: Before you get on me about how diversified quantitative long-short value is not the same as doing bottom-up fundamental analysis, I agree with you. But if you invest in relatively cheap stocks and sell relatively expensive ones, you are giving your portfolio a quantitative value tilt, and so my observations may still apply to you.)

Value’s Been Historically Bad – Is It Cheap Now?

Long-short quantitative value has stunk in the past decade, reversing the 50-year trend that earned fame and fortune among many a bespectacled, bowtie-clad accounting nerd. It's been a bummer for a lot of old-school stock pickers.

According to Two Centuries Investments, we’re approaching the worst performance for value since the first industrial revolution.


While many investors love to blame the Fed for poor price discovery and risk-agnostic malinvestment following the financial crisis, AQR did a data-driven survey of the field and failed to find a compelling connection between low interest rates and trouble for value. The researchers basically ended up throwing their hands in the air, saying value investing is hard, and that’s partly why it has strong long-run returns. This is part of the game; toughen up or index.

It’s important to understand, I think, that even the seasoned, educated, and reputable pros like the folks at AQR don’t have a great explanation for why value is getting hammered. All they can say, more or less, is something along the lines of investors don’t care about valuation the way they used to. Well, that, and, value spreads are historically wide right now – value is cheap.

Now, AQR runs billions in strategies with value exposure, so they want value to do well, so they’re going to talk their book. But I find their analysis compelling, since it debunks many intuitive narratives about why value hasn’t been working: book-to-price isn’t real value; tech stocks have taken over the world; megacorporations have taken over the world; etc. Those explanations don’t seem to hold up to statistical scrutiny.

That doesn’t mean there isn’t some good reason for value’s failings. A strategy that has been failing to work can continue to fail for a long time or even forever. But I believe two things about our current environment:

  • In the long run, investors tend to care about relative valuation
  • In recent months, investors have arguably cared as little about relative valuation as they ever have

Given we’re at an extreme of poor performance for value quant strategies, investors with a great deal of exposure to expensive names, even names with justifiable valuations on other important metrics like earnings quality, “moats,” future growth prospects, etc., should at least develop a realistic downside risk assessment for their portfolios and consider reducing equity exposure.

A Volatility Tell For Value?

An intuitive way to understand stock market cycles is that investors reevaluate their approach as prices are falling. They’re human, the market is punishing them, and as they endure their losses they rethink their investment processes.

Realized volatility of a strategy’s return – the range of possible outcomes that the strategy has lately shown -- may be one signal investors are reevaluating the strategy's merits. We are currently seeing a rise in realized volatility for long-short value strategies.

The last time long-short value was this noisy was in the throes of the Financial Crisis. The time before that was as the dot-com bubble was unwinding. In the case of housing, the spike occurred well into the crisis. In the case of the dot-com spike, this measure reached significant new highs before the stock market began its descent. I don’t think long-short value's volatility is a market timing indicator, but I do wonder whether it can tell us investors are reconsidering their approach to fundamental stock valuations.

The stock market dropped dramatically in the first quarter of 2020. Long-short value return volatility began spiking right around March. But stocks have since rebounded in the second quarter, and despite a brief rally for value, the pain has resumed. Are these tremors signals of a pending shift for value? I tend to think so.


“Price momentum is about the only thing I know out there that’s your friend in an irrational bubble”

In the Acquirers Podcast Cliff Asness said price momentum – the tendency for stocks that have been going up to continue going up and for stocks that have been going down to go down – was the only factor that continued working deep into the dot-com bubble of the 1990s. Unlike value, momentum has been working for the past decade, although sledding has been rougher in the very recent past.


Economic explanations for momentum include that investors are too slow to price in news that affects individual stocks, as well as herding -- the tendency for people to "follow the crowd" as it buys or sells individual investments.

There’s evidence today that retail investors are piling into the stock market, and that lockdown-induced boredom has prompted a lot of people to start screwing around on Robinhood. In those circumstances, you might expect day-traders to ride stocks that have been going up, and to ignore valuation. If those circumstances reverse, they could presage a broader re-evaluation of how we price stocks, as well as a broad repricing of stock market risk.

Naïve traders are unlikely to persist in the markets if the pandemic continues to drive economic stagnation. Most people will pull money out of a just-for-fun brokerage account to make the mortgage or buy groceries. But even if we set aside the daytraders, how long can even the smart money continue to “look across the chasm” regarding COVID-19 and its economic fallout? The longer the shutdowns last, the harder it will be to recover from related economic damage. The numbers seem to show we’re very far from out of the woods regarding the disease. If the situation gets bad enough I believe investors will have to start pricing stocks a lot more soberly.


With that in mind, let’s get back to momentum: Here’s a chart showing 12-month realized volatility of returns, just like the one I did for value above. I have two observations.


First, momentum is a very high-return strategy, but it’s also the most volatile of the major quant factors - it’s fickle. Second, volatility of returns to momentum strategies has spiked lately, again to levels last seen at the dot-com peak and amid the financial crisis. Momentum is getting noisier. Could momentum’s volatility of returns be a signal that investors are re-evaluating their approach to the stock market? Again, I think so.

While they’re kicking the tires on value and momentum, investors may also take more interest in the stock market’s absolute valuation. Relying on the trusty old Shiller CAPE, as of right now, I would not call stocks cheap, even for a pandemic-free world.


Conclusion

I don’t know of any way to precisely time the market or to time investment strategies, nor to my knowledge does anyone else. I am bearish on stocks on the macro outlook for the U.S. economy, and this view is largely tied to the COVID-19 pandemic, although I think stocks are expensive even for rosier conditions than the ones we face.

I believe returns to value-driven investment strategies are long-run positive and mean-reverting. This means I believe that the decade-long downturn in quant value strategies is unsustainable, though I don’t know when a rebound may take place. (Nor am I invoking the gambler's fallacy to say we are due for a rebound in value.) There is no guarantee that a rebound for value would accompany a broad market meltdown or even a long stagnant period for stocks, but those are the easiest outcomes for me to picture given absolute stock market valuations. So I am now among the many investors who are bearish on stocks and risk assets, and I’ve trimmed my equity exposure accordingly.

I don’t think I’ve found a short-term predictor of market moves or strategy returns, but I’m interested in the recent spike in volatility of returns to both value and momentum factors. So far the market has been able to look past deteriorating economic fundamentals in the U.S., so poor investment performance will have to be driven by a reordering of investor priorities. We failed to see such a reordering during the Q1 COVID crash, but returns to value and momentum strategies each appear less stable today than they’ve been in a decade, and I can’t help but wonder whether that rising instability portends a broader paradigm shift among investors. Regardless, now is a good time for investors to be honest about what they believe is driving their portfolios, assess sources of both return and risk, and do their best to align their investments with their willingness and ability to endure a broad market downturn or a long period of stagnation.


A revolutionary initiative is helping average Americans find quick and lasting stock market success.

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