If not now, when?

Article 14 November, 2022

As I’ve been watching market events unfold over the last several weeks, but particularly following the recent Federal Reserve meeting, I’ve increasingly been asking myself the question: if investors aren’t deploying capital to valuation-focused equity investors now, when will they?

Written by

William Lough

Let’s start with an admission – I count myself among said valuation-focused investors, so I clearly have an axe to grind. Looking objectively at the evidence, however, the stars do appear aligned for an extended period of performance for cheaper equities over their longer duration cousins. Outperformance for this cohort has, of course, already started – and we discussed the foundations for this in detail in the middle of last year – but we’re still in the foothills from a relative performance perspective.

There are three reasons I think investors should be allocating now:

the Fed has confirmed that rates will end up at higher rate level than previously anticipated – investors should be under no illusions that we are in a different market regime to 2010-20;
valuation dispersion – a measure of the bang for your buck you get for buying cheaper stocks over more expensive – is now at high levels across the world;
perhaps most importantly, the fundamentals of last cycle’s darlings are cracking while cheaper stocks are actually performing better. Investors have begun to take notice of this last point with share price technicals also now turning down (the last shoe to drop).

1. The Fed has confirmed that rates will end up at a higher resting point

One of the key messages from Fed Chair Powell was that the pace of rate hikes will moderate in 2023. If you’re really bearish about the stickiness of inflation then this is likely to sound like wishful thinking but, taking him at his word, we can think of this process as like the foot coming off the throat of overall equity valuations. Rate-of-change generally does the most aggressive damage to asset pricing, as investors have to price in a new reality, so following the fastest tightening in global financial conditions on record (once quantitative tightening and the US dollar’s rise are considered) this is a welcome development.

But before growth investors pop the champagne corks, the sting in the tail is, of course, the higher ‘resting heart rate’ of interest rates. The chart below shows – in quite technical terms – the relatively straightforward conclusion that higher discount rates are disproportionately bad for longer duration assets. Yes, these have fallen already this year; no, we do not think that they have yet corrected enough to fully embed the changed cost of capital regime, particularly as the business fundamentals for many are starting to creak (or crack).

Source: Credit Suisse HOLT

“...if you’re waiting for macro conditions to improve before upping equity allocations, remember that historically if you wait for PMIs to trough, you miss 1/3 of equity market recovery. There’s never a flashing sign saying, “this is the bottom"...”

2. Valuation dispersion is now high wherever you look in the world

My strongest conviction is that certain equities are much further through the process of adjustment to the intermediate outlook than others, allowing scope for stock picking alpha.

We like to look at valuation dispersion – the gap between cheap and expensive stocks – on a sector-neutral basis and using a blend of valuation metrics. Both help dull down ‘noisiness’ of the data and the issues that can come from using an index that is too heavily weighted to, say, tech or commodities companies.

Recently, something happened that hasn’t happened since 2011-12. Every one of the major regions tracked by AllianceBernstein research is now in high dispersion, whereas until this year this was the preserve of the UK and Japan.

Valuation dispersion for developed markets is now high in every market…

Source: AllianceBernstein LP. Data to 4 November 2022.

…and extreme in some like the UK

Source: AllianceBernstein LP. Data to 4 November 2022.

In itself this creates excellent stock picking conditions for valuation-focused investors, however the relative merits are turbo-charged when the next point is also in play…

3. The fundamentals of last cycle’s darlings are cracking

This is perhaps the most important of the three points because it’s the newest. The most notable feature of the Q3 earnings season thus far has been big tech missing analyst expectations, accompanied by guidance which has led to downgraded forecasts and share prices putting in what technical analysts call ‘confirmed breakdowns’.

If you’re still up to the gills in the large cap tech, best to look away now…

Source: Bloomberg Finance LP. Data to 9 November 2022.

Most commentary on the ‘next leg of the bear market’ focuses on earnings downgrade risk at the benchmark level, which is of course still dominated by these companies. This misses that other parts of the stock market, including areas with much cheaper starting valuations, have either already seen earnings forecasts reduced more materially or are simply doing better in the current environment. Think banks and energy stocks, but also companies which benefit from robust capex spend required to deliver strategic priorities (such as decarbonisation or supply chain security) for corporates and governments, which we discussed in a prior thought piece.

EPS forecasts for banks are improving while big tech is cracking

Source: Bloomberg Finance LP. Data to 9 November 2022.

In January, I wrote the following:

We find the market message of 2021 really rather extraordinary. Starting the year in the grip of a new Covid wave, US CPI ends +6.8% year-on-year, real GDP growth is +4.2% and the unemployment rate is just 4%. What is remarkable in this context, though, is that US 10-year bond yields end at 1.5% and the S&P Growth index is up over 30% (handily outperforming its value cousin). What to make of this continuation of the trend of the last few years, despite an undeniably different economic regime? For some, the takeaway from this episode is that ‘the show goes on’ – just keep buying long-duration growth equities. Surely if they managed to outperform in the face of the highest inflation prints in 30-plus years then nothing can stop them, so goes the logic. This seems to us a bit like standing on the banks of a crocodile-infested river, watching three people try to swim across and get eaten then a fourth make it across alive and assuming that it’s safe to go in the water. Historically, the behaviour within equity markets hasn’t decoupled from economic reality for long. To suggest it will continue to do so now strikes us as reckless. If both common sense and the weight of historic observation suggest it’s not a good idea, we fear investors extrapolate the market behaviour of 2021 at their peril…

Well, we now know the crocodile-infested river was indeed dangerous to swim in and – to stretch the analogy to breaking point – we’ve been able to navigate our way across, delivering returns well ahead of benchmark for our Global Sustainable Opportunities clients since the inception of the strategy last November, by building a balanced and robust portfolio rather than by making a major directional bet on a single macro outcome.

Is now the perfect time to invest in equities? I don’t know. Is now the perfect time to perfect time to invest in value-style equities? I still don’t think that’s an answerable question. Is now an excellent time to invest in stock pickers with a clear valuation bias? Yes. Too often recently I’ve heard about trying finesse the sale of growthier managers (“we’ll wait until manager X has a better period of performance then sell”) to scale up positions with the cheapskates. Joining the dots from the evidence today and looking at precedent cases, investors should be allocating now, in size, if they haven’t already.

And if you’re waiting for macro conditions to improve before upping equity allocations, remember that historically if you wait for PMIs to trough, you miss 1/3 of equity market recovery. There’s never a flashing sign saying, “this is the bottom” and the one thing we can almost count on is that when the bottom does come, the economic headlines will probably look “godawful”, to quote one rather famous nonagenarian US investor!