The difference in valuations between expensive and cheap stocks has overshot in recent weeks. Investors can therefore expect a period of outperformance of value stocks. However, this will not last too long.
Investors’ asset allocation consensus now seems stronger than it has ever been. Pretty much all investors are overweight in quality and growth stocks, avoiding the sectors most affected by the corona crisis.
‘Market positions are absolutely radical now,› says Geoffroy Goenen, head of European equities at Candriam in an interview with Investment Officer. An important reason for the current ‹exaggerated positioning› is the reduced market liquidity, he says. ‘This is not just a problem of the bond markets. Equity markets in Europe have also lost two thirds of their liquidity since 2009 because banks no longer hold risk on their balance sheets.’ This has made it much more difficult, for example, to sell large holdings of shares, and increases volatility in a crisis situation. ‘It’s one of the main reasons for share prices having overshot in recent weeks’, says Goenen.
Georg Elsässer, who manages a long/short European equity fund at Invesco, points out that many investors were already in a defensive position before the outbreak of the coronavirus crisis. ‘The current crisis has led to even greater differences in valuations between sectors. Expensive shares have become even more expensive, and cheap shares even cheaper›.
Many investors have virtually given up value stocks, it seems. Even value investor par excellence Warren Buffett seems to have thrown in the towel. The investment veteran sold billions of dollars worth of airline shares earlier this month at a big loss.
Valuation spread
‘The market has really sold everything, and limited liquidity was the main reason for this,› says Goenen. Now that the market has calmed down, the valuation gap will therefore automatically close somewhat, he expects. ‘Momentum [for high-quality stocks] is now so strong that the chances of investors taking a massive profit at some point and thereby initiating a reversal are very high.’
Goenen has therefore increased the allocation to value shares in recent weeks. He draws the comparison with the aftermath of the financial crisis. Between March and July 2009, the banking sector also outperformed by 60%. ‘Something similar can now happen again, because many banks trade at a price/book value of 0.2 or 0.3. I expect short-term outperformance of value of at least 10-15%, but it could go even further. This can hurt if you’re not invested in such stocks.’
Elsässer from Invesco expects something similar. ‘The valuation spread, i.e. the difference in valuation between expensive and cheap equities, is now at record levels under the influence of very strong investor momentum. In the past, we have always seen a turnaround when risk aversion among investors fell again. So this could also be the moment when momentum in a small number of large stocks [such as Amazon, Microsoft and Facebook, who have led the equity rally in recent weeks] turns negative again,’ he says.
But timing is vitally important here, because the value bounce won’t last very long. ‘Once the valuation gap between value and growth is back to normal levels, you’ll need to sell value again. This is because the economic recession ahead will not make it easy for value stocks,› says Goenen. Countries that are now seeing their debt ratios rise steeply will eventually have to reduce their deficits. ‘I am therefore certain that in the longer term value will underperform compared to quality and growth stocks.’