By |Published On: March 9th, 2023|Categories: Research Insights, Factor Investing, Value Investing Research|

We wrote a couple of times about the valuation spread between the 10% cheapest stocks and the market.(1)

  • There was this piece from April 2020 showing that the spread was generally close to where it was in 1999. This was right after a very bad relative drawdown for value stocks, so it made sense value stocks were looking good.
  • Then in November 2021, I did an updated piece showing that spreads had, in fact, generally become even wider. They were now beyond 1999 on some measures. I concluded that while this was a large spread, things could always get wider.

Well…things got wider.

Where We Stand Now on the Value Spread

There are three “peaks” in the chart above: The 1999/2000 Tech Bubble, the 2008/2009 Financial Crisis, and today’s situation (We’ll call it “The Covid Bubble”).(2). All of those peaks show when value stocks are historically undervalued relative to the broad market.

The Tech Bubble and the Financial Crisis caused value stocks to become historically cheap. But they got there in different ways.

The Tech Bubble caused value stocks to become undervalued relative to the market simply because tech stocks were going up SO MUCH faster. Investors were buying everything. Value stocks did okay from an absolute return perspective but lagged on a relative return basis. I.e., some tech stocks were up 150%, whereas value stocks were up a measly 15%. You’d be happy if you received a 15% return in a year and didn’t know anything else. But because everyone’s proverbial brother-in-law owned those tech stocks (maybe even with leverage) and was up 400% in the past year, many investors had a serious case of FOMO. It’s wired into human nature for us to care about relative things (as an aside, this is probably why momentum investing works in the first place).

The Financial Crisis caused value stocks to become historically cheap because investors were *selling* everything. It’s said in a true crisis; all correlations go to 1. And that’s generally what happened then. Value stocks (a type of company that has questions about its future) were sold harder than the general market for one reason or another. Good companies were sold beyond what they should have because investors were scared. And this is one of the reasons it’s assumed value investing provided higher returns historically. Investors tend to “throw the baby out with the bath water.”

Today’s peak seems more like the tech bubble than the financial crisis. Expensive stocks were bid up to unfathomably high prices, while deep value type stocks have just plodded along.

Why Should I Care About Value Spreads at Extreme Levels?

Jack wrote a piece showing how value stocks did after the peak of the valuation spreads in 2000 and 2009. To no surprise, they did great. Jack then wrote a piece showing how momentum stocks did after the peak of the valuation spreads in 2000 and 2009. To somewhat of a surprise, they did better than the market but worse than value stocks alone.

If we zoom in on our valuation spread (below), we can see a tiny bit of compression. But we’ve also seen plenty of similar small compressions before.

We believe owning deep-value stocks is potentially interesting at these valuation peaks. But as I said in the previous two times I wrote this, the spread can get more extreme. At some point, we’d like to stop talking about the valuation spread and its potential effect on forward expected returns…and see that spread COMPRESS!

A theoretical example of what we’d like to occur to the valuation spread
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About the Author: Ryan Kirlin

Ryan Kirlin
Ryan Patrick Kirlin is Head of Capital Markets and Sales for Alpha Architect. He works with financial advisors to analyze and create affordable, tax-efficient, investment portfolios in partnership with Alpha Architect and our investment strategies. And, once portfolio decisions are made, assists them in executing fair ETF trades. His previous roles in the New York Stock Exchange's ETF Group (where he was part of launching about 650 ETFs) and at RevenueShares ETFs help give him a well-rounded view on ETF structure and the opportunities for investors within the industry. When RevenueShares was acquired by the mutual fund behemoth Oppenheimer Funds, Ryan received an inside look at the challenges faced by legacy asset managers in adapting to the future of asset management. Ryan attended Fordham University for his undergraduate degree. He was a member of the US Rowing Team in 2011 and competed at the Pan American Games. He stills rows and his backtested performance results look great. He's not as confident in his forward expected returns due to new unaccounted transaction costs in his life (family, age, and golf).

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For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice.  Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.

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