Even after this years equities rally, some market
imbalances created by the financial crisis in 2008 have not
disappeared. When these distortions unwind, we expect deep
value stocks to rapidly recover.
Its 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 (see chart
1), 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
Even investors shifting toward passive equities have
unwittingly exposed themselves to the same risks. For example,
by late 2012, 42 percent of the S&P 500 Indexs 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
Whats 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
(see chart 2). 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.