Equity Market Distortions Create Big Payback Potential

Even after this year’s equities rally, market imbalances created by the financial crisis in 2008 have not disappeared. When these distortions unwind, we expect deep value stocks to rapidly recover.

It's understandable why investors became so risk averse after global markets collapsed five years ago. But we think it went too far. The crisis prompted a seismic shift in how investors think about returns, as people lost faith in the ability to profit from the capital appreciation of stocks.

As a result, flows to fixed-income funds dwarfed flows to both US and non-US equity funds from 2008 to 2012 (Display), as investors preferred assets perceived as safer. Passive equities have become increasingly popular, while investors have shunned active strategies. And investors flocked to equity strategies focused on stocks with higher dividend yields while abandoning large-cap value equities, which are considered among the riskier types of stock investments.

By piling layer upon layer upon layer of safety, investors may have actually achieved the opposite. The perceived shelters of government bonds and high-yield equities are both sensitive to the same market forces: macroeconomic concerns and interest rates. When sentiment shifts and interest rates begin to rise, the layers of safety are likely to unravel; in this scenario, investors may discover that their diversification was an illusion and that they have less protection than expected.

Even investors shifting toward passive equities have unwittingly exposed themselves to the same risks. For example, by late 2012, 42% of the S&P 500 Index’s total market capitalization was invested in high-dividend-yield stocks, near the top of its historical range since 1970. Meanwhile, only a quarter of the market was invested in stocks with low price to book (P/B) values, toward the bottom of its historical range.

What’s behind this preference for high-yielding stocks? In the past, investors typically bought stocks to benefit from future growth and earnings. But in an environment where nobody believes that the economy or corporate profits can grow again, riskier higher-beta stocks have been shunned. Many low-beta stocks, which are generally perceived as safer and more stable investments, are in fact highly correlated with bond yields (Display). So when bond yields eventually rise from current historical lows, these stocks are unlikely to provide much protection. In contrast, deep-value, low P/B stocks are negatively correlated with bond yields, so they can be expected to perform better as bond yields rise.

In recent months, we've seen initial signs of a revival of confidence in equities, as flows into stock funds have started to pick up again. However, investors are still scarred by the crisis years. In the past, a relatively narrow range of outcomes for a given investment scenario gave investors confidence to put their money in assets that would take a longer time to pay back a larger reward. But after the crisis, the range of outcomes seems much wider—and the downside is much more frightening.

Lower tolerance for uncertainty and a lingering concern that the environment remains highly uncertain have led many investors to rein in their time horizons substantially. Against this backdrop, deep-value stocks, which typically take a very long time to work their way out of controversy and deliver big returns, are simply not on many investors’ radar screens.

While the deep insecurity that investors feel has undermined value investing, we think the recovery potential for deep-value stocks will be huge when market distortions unwind. Since the distortions are so acute, we believe that a repricing of deep-value stocks could happen very quickly.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Joseph Gerard Paul

Chief Investment Officer—Strategic Equities and US Value Equities
Joseph Gerard Paul serves as Chief Investment Officer for Strategic Equities, appointed in 2014, and US Value Equities, appointed in 2009. He has also served as CIO of the Advanced Value Fund since 1999. Paul was previously CIO of Small & Mid-Cap Value (2002–2008) and co-CIO of Real Estate Investments (2004–2008). Additionally, he was the director of research for the Advanced Value Fund for two years. In that role, Paul was instrumental in the genesis of the Advanced Value leveraged hedge fund. He joined Bernstein in 1987 as a research analyst covering the automotive industry, and was named to the Institutional Investor All-America Research Team every year from 1991 through 1996. Before joining the firm, Paul worked at General Motors in marketing and product planning. He holds a BS from the University of Arizona and an MS from the Massachusetts Institute of Technology’s Sloan School of Management. Location: New York

Kevin F. Simms

Chief Investment Officer—Global/International Value Equities
Kevin F. Simms, an AB Partner, was appointed Chief Investment Officer of Global and International Value Equities and chairman of the Global Investment Policy Group in July 2014. He has held the position of Chief Investment Officer of International Value Equities since 2012, after having served as co-CIO since 2003. He was also the Global Director of Value Research from 2000 to 2012. During his tenure as chief investment officer and research director, Simms has been instrumental in implementing significant enhancements to the firm’s cross-border research process. From 1998 to 2000, he served as director of research for Emerging Markets Value Equities. Simms joined the firm in 1992 as a research analyst, and his industry coverage over the next six years included financial services, telecom and utilities. Prior to that, he was a certified public accountant with Price Waterhouse. Simms earned a BSBA from Georgetown University and an MBA from Harvard Business School. Location: New York

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