It's Always Darkest Before the Dawn

Executive Summary

  • Before the current downturn, the market was offering up very attractive relative equity opportunities as some pockets of the market were much cheaper than others.
  • Bear markets often play out in three phases, with cheap assets outperforming in Phases 2 and 3. This potentially presents an opportunity for the valuation-sensitive investor willing to buy cheap assets today.
  • U.S. and non-U.S. markets have fallen roughly in tandem in local currency terms maintaining their historically wide valuation spreads; Europe, UK, and Japan Value stocks are cheap in absolute terms while Emerging Market (EM) Value stocks are extremely cheap.
  • The U.S. dollar has strengthened against a basket of EM currencies, leaving EM currencies 1.4 standard deviations cheap relative to history.
  • In a sharp drawdown, correlations among assets rise. Once peak volatility fades, however, these dynamics will renormalize. Now is the time to act on your portfolio allocation.

It has been an extraordinary four weeks in markets worldwide. In the past 20 trading sessions, the S&P 500 has seen more 3%+ daily swings than it had in the previous 5 years. Equity markets globally, with few exceptions, have plunged, delivering the fastest -30% moves on record for most indices. Fixed income markets are turbulent, with liquidity so sparse that U.S. Treasuries – the safest of assets – have seen bid-ask spreads widen beyond 1 point.1 Then there’s the cheap stuff.

When Cheap Gets Cheaper

Prior to the downturn, we were excited by the extraordinary spreads between cheap and expensive assets. At the beginning of the year, EM Value stocks looked poised to deliver double-digit returns over the S&P 500. We also predicted Small Cap Value stocks would trounce cap-weighted indices in the U.S. and in the rest of the developed world.2 The gap between Value and Growth looked extremely wide across global markets, reaching levels unseen outside of the Tech Bubble. Yet cheap assets kept getting cheaper.

It is not a particularly pleasant feeling to own an asset whose price has dropped. It is doubly uncomfortable doing so when that asset was not covering itself in glory during the good days. But we do not decide whether to own an asset or not based on how it has felt to hold it historically; we do so on our best judgment of the future returns we believe the asset can deliver. And many of the cheap assets of yesterday, pandemic notwithstanding, seem quite likely to outperform.

Perhaps this gives you pause. Assets tend to be cheap for one of two reasons – either because their future growth expectations are low, or because their perceived risk is quite high. Often, both. Holding a basket of potentially risky companies during a period of heightened uncertainty, with market volatility as high as it is, can feel terrifying. As far as history is concerned, however, cheap assets have been a winning proposition during bear markets.