Executive SummaryIn the last of our asset-class valuation series, I discuss costly value traps that can derail even the best-reasoned asset-class value themes. A lot can go wrong when you bet on value. In particular, an asset class that appears to be an excellent value can stay that way for years.
All investors face this problem and most professional investors who manage billions of dollars have only one option, which is to leg into these investments over time. Asset class traders have the benefit of being small enough to wait for a catalyst before trading a compelling value opportunity. In this blog post, I review various catalysts I use to get the timing right and avoid the value traps.
As described in previous posts, compelling values are rare situations when an asset class trades at prices well below intrinsic value due to human behavioral quirks. Sometimes prices may seem rational at the short and intermediate time scales but are irrational on long (5-10 year) time scales. Such an assessment is truly a long-term variant perception and essentially a bet that you’re smarter than the market. There are many ways this bet can turn sour. Below are four value traps associated with using valuations to select asset classes.
Value trap #1: An improper assessment of valueCheap asset classes are often intriguing, and value charts can be devilishly misleading. As discussed in my critique of the CAPE ratio and my last post on compelling valuations, hindsight and selection biases are hidden in every valuation chart. Historical charts, which form the basis for essentially all valuation assessments, must be carefully scrutinized.
Inexperienced and naive investors can be attracted to high yields and low multiples without thinking about why these valuations exist. The opportunity is likely too good to be true, with the analyst missing additional risks embedded in the pricing, or stale accounting values and other pitfalls. I’ve made many errors of this type in assessing cheap asset classes. Every effort must be made to account for all logical explanations for current asset-class prices.
As an asset class trader, we must accept and factor in the possibility that our assessment of a compelling value opportunity may be wrong.
Value trap #2: A good value can remain a good value for yearsValue works on long time scales. Over short time periods, such as the next 12 months, prices can easily move in the opposite direction due to a variety of short-term forces. Assuming we’ve assessed the value opportunity correctly, we must acknowledge that it can take years before market participants recognize that the asset class is irrationally too cheap.
Often, a compelling value is set up by a mega-growth trend associated with a different asset class, such as when value stocks were ignored in the late 1990s because most investors were succumbing to internet-stock tunnel vision. At times, betting on the compelling value can be viewed as shorting the popular asset class, and we know that standing in the way of a secular freight train is a risky thing to do with your portfolio.
The old investor adage states that being too early looks a lot like being wrong. Many value managers ignore this timing issue and buy. Their plan is to buy more when prices fall because the value becomes even more compelling. Eventually, the ability to buy is capped by capital constraints or position limits. Large institutions have no choice but to leg into these trades over time since they can’t react quickly if the trend suddenly changes.
Developing a trading plan that accounts for this timing uncertainty is essential. An asset class trader’s ability to get the timing generally right is a trading edge for us. If prices continue to fall, or the asset class continues to underperform, we can wait with no position until the trend changes.
On a side note, market doomsayers who predict bearish market crashes, government defaults, currency crises and other calamities are also highly susceptible to the two-value trap issues described above. One day such an assessment may be right, but it’s not a great way to make money by shorting a market and waiting for a coming collapse. Plus, the likelihood of such a bet working is low since these trades are fundamentally misaligned with the incentives and efforts of CEOs, central bankers and government officials who are fighting every day against the calamity scenario.
Value trap #3: Fundamentals change for the worseWhile waiting for the market to come around to our opinion, the fundamental economics associated with the trade may get worse. Emerging market equities appeared to be an excellent value coming out of the 2015-2016 mini-bear market. They indeed outperformed the world stock market indices until Donald J. Trump was elected president of the United States in November 2016. His America-first policies have hindered that trade ever since.
Value trap #4: Avoiding “slightly overvalued” asset classesValue investing is an attractive investing discipline because there’s an overwhelming body of evidence that it works over time. That’s attractive to a science-based logical thinker like me. Also, as investors gain experience or perhaps accumulate battle scars, it seems they become less prone to fall for the pie-in-the-sky growth stories and investment fads. With more to lose, seasoned investors may also reduce their risk tolerance over time.
If value investing has seeped into your asset-class trading discipline, then it may become harder to buy asset classes that appear overvalued. This is not quite a traditional value trap, but I think it’s worth highlighting. I think I’ve developed a bias against growth stocks due to my strong view that value investing works over time. I’ve had a lot of success with value investing. This has also led me to avoid “over-valued” asset classes at the margin, even though logic suggests these expensive asset classes are probably priced correctly. At other times when I’ve had few trading edges in the equity space, I’ve tended to tilt my portfolio toward my perception of value, even though the uncertainty associated with the assessment was quite large.
Even Warren Buffett came to the realization that he couldn’t limit the search for good investments among cheap assets only. A great company at a fair price can be just as good an investment as a good company at a cheap price. All asset class traders and investors need to realize that the same applies to asset classes. The CAPE valuation critique showed that a rich valuation can at times be rational and appropriate.
Thus, when weighing the pros and cons of an asset-class trade, we need to be careful not to put “overvalued” on the cons side of the ledger when the asset class is probably fairly valued. Valuation is only added to the pros/cons table when the value is compelling on the long side, or if bubble-like behavior is pushing prices well above intrinsic value.
CatalystsThroughout history, catalysts for long-term trend changes have been called many things. A few examples include sea change events, regime shifts, watershed moments, inflection points, turning points, seminal moments, fulcrum moments and secular pivot points.
A great value can stay a great value for an excruciatingly long time, so waiting for a timing catalyst should help enhance returns by not tying up capital in a trade that’s not working. While we wait, the asset class may lose value, or more likely, lag the benchmark and other investments.
Some equity value managers suggest value is itself a catalyst. I can sympathize with that point of view in the stock market arena since it’s now a requirement that every stock pitch needs a catalyst, and thus it makes sense that the probabilities associated with a variety of known catalysts is now factored into stock prices.
As an asset class trader, compelling value opportunities don’t happen very often and are long-term in nature. For us, it makes no sense to buy and hold an undervalued asset class without a variety of clues that the long-term trend in underperformance has changed. Yes, we risk missing a sudden sharp move higher, as the asset class is instantly repriced to intrinsic value. This doesn’t happen very often. We normally expect a successful trade to entail a multiyear period of outperformance as prices eventually catch up to an ever-increasing intrinsic value. An overshoot beyond intrinsic value may also occur many years down the road.
Waiting for a catalyst also mitigates the other value trap risks – specifically, that our analysis of the situation is just plain wrong. Here are the primary catalysts I look for in timing a bet on a compelling value opportunity.
Long-Term Trend ChangeDepending on the asset class, we’re trading either price or the relative performance of one asset class with another. We’re observing long-term price action to confirm the price trend has indeed stopped going down and appears to be bottoming or trending higher.
I describe this process in my blog post on long-term relative strength line trend changes. We’re waiting for a long-term trend change, so we must ignore short-term trends and market action in this assessment. A new 12-month high can serve as such a catalyst. Similarly, when an undervalued asset class tops the 12-month return tables among all asset classes, we could consider that a catalyst. The drawback with this approach is it can take a year from the bottom before an uptrend is confirmed.
Market TellsObserving our undervalued asset class act strong when it should be weak on the intermediate and long time
scales is a strong signal the timing is right to make the bet. I’ve written two blog posts describing how to search for market tells. Market tells are common at major turning points because market participants are often leaning the wrong direction when a new secular trend begins. Market tells allow you to jump on a trend change much faster than waiting for the long-term price trend to change.
Massive Capitulation or CrisisSuppose we’ve been stalking a trade in an asset class that appears to be a compelling value. If we observe the price or relative strength line fall dramatically in a parabolic fashion over a 1-3 month period, it’s worth the bet to buy the compelling value as prices plunge.
First, buying into a washout like this generally works in all situations leading to above-average future returns. If the sell-off is driven by investor outflows capitulating on the asset class or a levered holder forced to sell, then this is a motivated selling event, which is always an automatic buy. For less liquid assets, putting bids well below current prices can provide an additional trading edge as liquidity dries up during the sell-off.
If there’s a crisis associated with the sell-off, then the current news might be the catalyst to buy when others are panicking, perhaps as the risks they’ve feared are finally manifesting. Buying European banks trading well below book value after the Brexit vote in June 2016 is one example of this approach. A more conservative option is to watch how the asset class responds to the selling for signs of underlying strength.
Ultimately, with this catalyst, we’re betting that the crisis and panic selling will mark the long-term low for the asset class.
Cyclical Bear MarketBear markets tend to reset mindsets. No one is obligated to hold a portfolio that worked during the previous cycle. Investors nursing big losses become less enchanted with the previous cycle’s winner and look to new investment opportunities elsewhere. Look for long-term trend changes when the new bull market gets going. The longer and deeper the bear market, the more likely there’s a trend change.
Bubble Popping ElsewhereBubbles suck up capital and investor attention, creating a dearth of capital to invest in the less exciting asset classes. When the bubble eventually pops, investor attention and money flows begin to trend toward the often-ignored asset classes. An example of this catalyst is when the tech stock bubble finally popped in March 2000. The peak immediately triggered the start of a multiyear period of outperformance among neglected, old-economy value stocks, REITs, commodities and U.S. long bonds.
A Sudden Investor Mentality ShiftWe don’t need a bear market or a bubble to have a sudden shift in investor mentality toward a compelling value. A major shift in central bank policy can work. Regime changes in the fundamentals driving the markets, new political movements, wars or a big move in another market such as oil, interest rates or currencies can awaken investors to new drivers of asset returns.
Pension funds may change how they structure and think about their portfolio design. The rise of populism or the emerging second wave associated with ESG and impact investing could trigger a major attitude shift towards an ignored asset class. A wave of mergers, corporate actions, bankruptcies, management changes and restructurings can also serve as triggers for change.
Also, I’ve found that while it’s worth noting the variety of anecdotal “bottoming signs,” we can’t rely only on them. Examples include insider buying, or when a fund manager who specializes in the undervalued asset class closes shop due to frustration, outflows and bleak future money-raising opportunities.
With the mentality-shift catalyst, it may be best to wait for confirmation with good price action.
When can we ignore the need for a catalyst?While our strong preference is to wait for a catalyst, there are situations when buying a compelling value and waiting can work for a portfolio.
The first reason is that returns associated with the undervalued asset class are uncorrelated with the rest of the portfolio. This is usually the case for new asset classes, where we get paid to wait with uncorrelated returns while the novelty premium dissipates over time. Compelling value privately-held asset classes, which are not marked-to-market every day, can also enhance risk-adjusted portfolio returns. When an entire portfolio consists of short- and intermediate-term trading strategies, then adding a long-term, compelling value is diversifying.
Commodities typically have a low correlation with stocks and bonds, so if there’s an excellent value in this space, it may be worth purchasing some before a catalyst presents itself. A hardening market among reinsurance rates can occur after massive catastrophe losses. Buying cat-bonds that offer attractive net-of-expected-loss yields (due to the lack of capital) does not require a catalyst since the return stream is uncorrelated with stock and bond returns. The lack of correlation is key with this “paid-to-wait” theme, not high income.The second reason is that we have additional trading edges in play. Perhaps we have a stale pricing edge to be exploited or an upcoming period of strong seasonality. Can we enhance returns trading around positions, providing liquidity, or selling puts while waiting for the market to recognize the value? Tax-loss selling or buying a closed-end fund trading at a significant discount can lead to a short-term trade to the upside.
The third reason is that the market is so illiquid that we’re large enough to move prices with our purchases. Obviously, the big boys who manage billions in assets are forced to buy early. But there are many small, illiquid markets that may require even small asset class traders to buy on weakness and perform a cost-benefit analysis associated with buying without a catalyst.
Whenever price falls below fair value, the phasing of buying is very much an art. We don’t know the ultimate extent of the downside or the timing of the bottom. Ultimately the need for a catalyst will be judged with all the above considerations. The higher the conviction level and the more compelling the opportunity, the less need there is for a catalyst. A combination of strategies, some that require a catalyst and some that don’t, is often the right compromise.
Current status of international and emerging market value vs. U.S. growth stocksIn a previous blog post, we introduced the idea that international, emerging market and value stocks may be a compelling value, especially compared to U.S. growth stocks. How might we use a timing catalyst to buy into this trade?
Over the past couple years, a few market strategists and asset allocators have suggested that EM stocks looked attractive, perhaps representing a compelling value. The extreme version of such a trade is comparing emerging market value stocks versus U.S. growth stocks. These asset classes hold very different companies.
Figure 1 shows a five-year chart of the Schwab Fundamental EM Large Company Index ETF (Symbol: FNDE) versus the iShares Russell 1000 Growth Index ETF (Symbol: IWF). My interest is in the blue line in the bottom clip, which is the relative strength (RS) line of EM value (FNDE) versus U.S. growth (IWF).Going into the bear-market bottom of 2015, EM stocks had underperformed significantly since 2010. The blue RS line bottomed in early 2016, and we observed a couple catalysts that suggested a large bet on EM was warranted. First, we experienced a bear market, which always has the potential to trigger a long-term trend change. Second, we observed a market tell (see Figure 1 of Market Tells – Part 1), where EM stocks were acting strong when they should’ve been weak.
Figure 2 shows the same chart but uses the iShares MSCI EAFE value ETF (Symbol: EFV). International value stocks continue to fall relative to U.S. growth stocks with no end in sight. Two mini-bear markets have triggered no change in the long-term RS line trend. There’s no reason to buy international value stocks, even though their valuations are cheap and are perhaps irrational on a long time scale.
Perhaps the catalyst that will eventually trigger a bottom in EM, international and value stocks is a longer and deeper bear market than the mild corrections seen in 2011, 2015 and 2018. Valuations may go from “being cheap compared to U.S. growth stocks” to a compelling, absolute value with expected returns in the 10-15%/year range. Another possible catalyst would be a bubble-like, blow-off top in the popularity of U.S. growth stocks, like what happened in 2000.
ConclusionsIn this blog post I discuss four classic value traps associated with using a value approach to select future outperforming asset classes. The value traps fall into two categories: errors in assessing value and getting into the trade too early.
To mitigate the risk associated with these value traps, I highlight potential catalysts that can trigger trend changes in favor of the undervalued asset class. An asset class trader is wise to wait for a catalyst before entering a trade based on valuations. I also discuss situations where it may be appropriate to buy a compelling value without a catalyst.
Ultimately an asset class trader must develop a game plan to take advantage of a compelling value opportunity. Each situation is different and requires some combination of waiting for a catalyst and buying now.
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