Over the last few years there have been many false dawns in the battle between value investing and growth investing and consequently, I think many investors have given up on the idea that there will ever be a sustainable rotation from growth to value that persists for an extended period. 
It has to be said, however, that as rotations go, the most recent move has been a big one, which does make one wonder if something more significant is happening.
The following chart gives some idea of how extreme the rotation was.
Source: Bloomberg, 12th November 2020
Whilst we cannot say definitively that this trend is going to continue, we can make the following observations about what might have caused the most recent moves.
- The gap in valuations between value and growth was at record levels, bigger even than that which existed in March 2000 at the peak of the dotcom boom.
- Market positioning was very lopsided, with many investors having crowded into the most popular stocks such as US technology/FANMAG.
Source: BoA Global Fund Manager Survey, 30th October 2020
- Liquidity is poor. I still think investors underestimate the ease with which blocks of money can be moved around the market, even in some of the FTSE 100 stocks. Since the market crash in March, while there has been an increase in market volumes, market liquidity has deteriorated.
These three conditions created a very unstable situation and that is why we have seen such a violent move. More importantly, these three conditions have not gone away despite recent moves and that is why it is possible that they may continue.
So, where does that leave us now?
As none of us have crystal balls, we cannot say for certain that this is the start of a new regime, but there are certain things that seem possible to me even as markets appear to be pricing them as very low probability events.
Firstly, there was already a recovery coming through and it must be possible that this continues into 2021, especially if we are able to end the policies of rolling lockdowns of the economy.
Source: Bloomberg, 30th October 2020
Secondly, the vaccine will reduce the chance of measures which have damaged the economy this year being repeated. Most governments are now aware of the massive economic damage that has been done by repeated lockdowns and I do not think they are keen to repeat them. The news on the vaccine thus offers them a potential exit route from this policy.
Also, both monetary and fiscal stimulus measures are still enormous. The Bank of England has just announced a further £150bn of quantitative easing, bringing the total to nearly £900bn. Meanwhile, the Federal Reserve are on course to have expanded their balance sheet from $4-9trn this year which is very significant when compared with the fact that it took them 10 years post-global financial crisis to go from $1trn to $4trn. Most other central banks are pursuing similar policies which collectively amount to a huge dose of monetary stimulus.
It is also worth pointing out that in contrast to 2009, this money is not going exclusively into financial markets because it is being used to finance governments’ deficit spending. This means that, in part, it is ending up in the real economy.
For stocks specifically, we think the following areas are particularly interesting now: cyclical stocks are still very undervalued, as the chart below demonstrates. Investors are currently being offered banks on less than half their book value, energy companies are on close to double-digit dividend yields (on already cut dividends), and retailers are on 5x our estimate of their long-run earnings power.
Source: Morgan Stanley, 30th October 2020
2021 could, therefore, see an economic recovery from very depressed levels in which the sectors that do the best are cyclicals and financials, whilst those that lag are defensives (healthcare, consumer staples, technology). If this is the case, many investors are currently tilted in the wrong direction to benefit from that.
In my 30-year career as a fund manager, there have been two occasions in which a market dislocation has created an opportunity for investors to make very attractive returns and I believe we are now witnessing a third. The first was in 2000 when investors became convinced that the future was in telecommunications, media & telecoms stocks and sold nearly everything outside of these sectors. This created a starting valuation in so-called ‘old economy stocks’ that virtually guaranteed attractive future returns (the price-to-earnings ratios and dividend yields of sectors such as tobacco and utilities actually crossed over).
The second occasion was in 2009 post the global financial crisis when a belief that the world’s financial system was under threat of collapse caused investors to sell not just those sectors most at risk, but anything remotely cyclical in nature. In that year, high-quality companies like Next plc became available at 5x their trough earnings (a 20 per cent earnings yield). It is important to note that these opportunities look obvious in hindsight, but at the time they required a contrarian mindset and a determination to look at the facts rather than yield to a powerful narrative created by many market participants.
The opportunity being presented today could actually be greater than the previous two because the dispersion in valuations is wider now than it was in 2000 and 2009. Investors may come to regret missing out on these gains because of their desire to hit the exact bottom.
Ian Lance is a UK equity manager at RWC Partners. The views expressed above are his own and should not be taken as investment advice.