Investors should tilt their portfolios toward “value” as the market may be nearing the end of a cycle in which “growth” and “quality” factors win, according to quantitative research from Bank of America Corp.
“We’re at the trickiest part of the cycle,” quant strategists said in a Bank of America Merrill Lynch research note dated October 18. “Institutional investors today have been funneled into growth and momentum stocks and are firmly underweight value and beta.”
The strategists said that “value” is neglected and cheap, while the “momentum” factor is crowded and expensive. The “unusually low” correlations between the two factors indicates “undue stress,” according to their research.
The market is now in the seventh month of a so-called downturn phase, which favors the stocks of companies that are large or have features including quality, low-risk, and “anti-value.” This phase has lasted an average of eight months before moving into the so-called early cycle, where stocks of small companies, beta, and “deep value” factors outperform, the strategists said.
Analyzing past inflection points, they found that “value fared best” in the period stretching from one month before the end of “downturn” phase through three months into “early cycle.” Their research shows that “value” gained 14.6 percent in this period, while momentum had the weakest performance at 5.5 percent.
“A violent rotation from momentum to value started in early September but largely ran its course by mid-month, at which point momentum stocks resumed leadership,” the quant strategists said. “In the year-to-date, value still lags other factors, and investors may have been lulled back into complacency on high momentum stocks.”
[II Deep Dive: GMO Is Feeling Pain Reminiscent of the Late 1990s]
In its third-quarter letter to clients, GMO said its pain is intensifying to levels the value investment firm last endured during the run-up to the stock market bubble of 2000. “As the current cycle has ground on slowly but surely, the valuation extremes have moved wider, creating an opportunity set for valuation-driven investors that looks as extraordinary as what we saw 20 years ago,” Ben Inker, GMO’s head of asset allocation, said in the letter.
The value factor is trading at an almost 25 percent discount to historical price-to-book value, according to the Bank of America Merrill Lynch research note.
An “anticipated re-acceleration” of earnings-per-share growth for S&P 500 companies in the first quarter of 2020, unusually low correlations between the momentum and value factors, and high valuation dispersions “all warrant a tilt toward value,” the bank’s quant strategists said.
