The Value Factor Wins In Downturns

There’s not straight-cut definition of value, other than stocks trading below their historical average (or benchmark average) price-to-earnings. Sometimes they’re cheap for a reason. Sometimes investors just got it wrong. Vincent Deluard, a global macro strategist at INTL FCStone in San Francisco says the average performance of the value factor during all market corrections of 15% or more showed value came out ahead.

Using 24 major market corrections dating back to 1931, four corrections occurred when the Shiller PE exceeded multiples of 25, as it is now. Two years after that correction, the value factor outperformed by an average of 25%.

The value factor wins. But there is a caveat: investors will have to be patient. Two years can be like a lifetime in the markets.

Recent market action suggests that aggressive themes are becoming investors’ “best defense” in a weird way. The down beta of various risk-on indices like European banks and U.S. value stocks have outperformed based on trailing 52-week beta.

“I created a model portfolio based on the concept of ‘anti-risk parity’ that keeps a cash balance of 25% and a 25% allocation to gold to protect capital,” he says. The “active half” of this model portfolio is invested in high-risk, diversifying assets like emerging markets, gold miners, European banks, U.S. value stocks, and even frontier markets. According to Deluard, the model outperformed a normal 60/40 portfolio (60% in the S&P 500 Index, 40% in the Barclays Aggregate Bond Index) by 4% this year, with a correlation of just 50%.

“Its variance would have been twice as high as that of the traditional portfolio, but this seems like a price worth paying for a fund that offers upside potential, while preserving half of its capital in cash and gold,” he says.

FCStone is warning clients that the next correction will be driven by a combo of geopolitical uncertainties, inflationary pressures and policy mistakes here at home. When inflation is the dominant fear, bond proxies like defensive stocks (dividend paying utilities) become the risky asset. Second, relative valuations are high. The growth premium has expanded almost continuously since 2009, Deluard says. Today, the Russell 1,000 growth index trades at a 200% premium to its value counterpart.

If you look at a chart of historical performance of the value factor since 1931 to 2011 it is unreadable because it’s so erratic. “There is just no regular pattern in the performance of the value factor during market corrections,” he says, which brings him to his own conclusion based on the above mentioned 24 cases. Value isn’t dead. But investors will need some patience. If Deluard’s models are correct, they will be rewarded for it.