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11 December 2019 Andrew Wellington, Lyrical Asset Management

Is this the beginning of an upcycle for value?

Andrew Wellington explains why the value downcycle, which has so far lasted around 20 months, could finally be coming to an end.

In early September we witnessed a dramatic change in markets. A seismic shift from momentum stocks into value occurred that was so significant JP Morgan described it as one of the largest three-day rotations between the styles in more than 30 years.

The scale of the shift has led us to ask if this could mark, at last, the bottom of the value downcycle that investors have been waiting for. Could it be a sign that value stocks will begin to outperform once again? We believe it might be.

In recent years, the stock market appears to have disregarded the fundamentals of stocks considered to be ‘value’. The current downcycle for value has lasted around 20 months to date, with stocks marked by low price-to-earnings ratios suffering painful underperformance since January 2018.

However, the rotation between 9-11 September saw value stocks rally by 7 per cent while momentum sold off 10 per cent. As well as being one of the largest rotations in the past three decades, JP Morgan also suggests it was a one-in-500 event that saw around five months of momentum outperformance lost in three days.

According to JP Morgan, the shift was triggered by better than expected economic data, monetary and economic stimulus, easing trade tensions and stabilisation in yields – yet we disagree.

Rather, we believe the situation in September was akin to an earthquake, with pressures on the long momentum, short value play in markets increasing to such an extent that it sparked a rotation.

While it is difficult to judge whether this is the end of the value downcycle in real time, we do believe that current cycle conditions mirror a pattern witnessed at the start of the five previous value upcycles, for three reasons.

Firstly, value upcycles typically start with a bang, with extremely strong outperformance in the first month or quarter. As a result of the shift out of momentum in September, value stocks soared and saw a month of excellent returns relative to the wider market. Secondly, this downcycle has lasted around 20 months which is the average duration of the last five value downcycles going back to 1960 – so the timing feels right. Our third reason is based on a historic trend which sees the worst months of a value downcycle occur in its final months. To quote Thomas Fuller, ‘it is always darkest just before the day dawns’, and in March, May and August of this year we witnessed extremely poor months of performance for value.

These three factors are common across past cycles, and mirror the pattern we see today. For example, when value began to outperform in December 2008 – in the depths of the global financial crisis – low P/E stocks had struggled for 17 months, only slightly shorter than the current downcycle. The upcycle began with a bang, with value significantly outperforming the market in December 2008 and January 2009 following the very worst months of performance in October and November 2008, the last months of value underperformance.

Before the financial crisis, the previous downcycle for value occurred during the tech bubble era, lasting 28 months from the start of January 1998. This marked the longest period of underperformance for the style in 45 years, but again the same pattern arose. Value significantly outperformed in the early months of the subsequent upcycle which began in March 2000, and the worst month of the downcycle, again, occurred in its last months, with February 2000 marking a particularly painful period for low P/E [price-to-earnings] stocks.

Looking at one more example, the turn of the cycle in the early 1990s again mirrors the same pattern. Starting in September 1989, low PE value stocks underperformed in 13 of the next 14 months until the upcycle began in November 1990 with strong monthly performance for value. Again, the worst two months of the downcycle came right before the shift, with September and October 1990 marking extreme underperformance for value.

We also witnessed a similar pattern in the early 1980s, when an 18-month downcycle ended again with a boom for value, and the worst months of the cycle came right before its end.

Each cycle is unique and not as predictable as we might like, but five of the most recent rotations bear a strong resemblance to current conditions. It is hard to ascertain if September did mark a new period for value outperformance, this is only something we can know for sure with the benefit of hindsight, but we are optimistic that it could be.
Good months for value have been rare for nearly two years, and from the above patterns we have strong reason to believe the September shift could be the beginning of the upcycle that value investors have been waiting for. The evidence is not conclusive, but does fit a historical pattern.

Nonetheless, whether the early September shift marked a new upcycle or not, we believe value stocks will return to their outperforming ways, whenever that day finally comes.

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