Improving the Odds of Value: II

Tactical versus Strategic Allocations to Value

September 2019. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Value investors earn a premium for holding undesirable stocks
  • The yield curve may identify periods where the premium is more attractive
  • Since 1971, the performance of the Value factor was negative when the yield curve was flattening

INTRODUCTION

Imagine a portfolio of companies that are plagued by declining sales, negative earnings, too much leverage, rating downgrades, CEOs that prefer golf over the board room, and corporate strategies that are sound as trying to conquer Russia in winter. These companies would be unloved by shareholders, but they also would be cheap.

What kind of environment would investors require to feel comfortable to take a wager on these stocks?

Investors would unlikely to be willing to speculate on the fortune of such a basket of Value stocks when they feel insecure in their outlook on the economy and stock market. We previously analysed the relationship between the Value factor and the skewness of the stock market in the US, which highlighted that nearly the entire performance of the Value factor can be attributed to when the market was skewed positively over the last year. Positive skewness implies that were no major accidents on the road behind (please see Improving the Odds of Value).

Market skewness can be viewed as a rear view-measure of what happened in the stock market and how investors might perceive the current risk environment. Naturally there are further measures to be considered for determining investor sentiment. One that has been central to all asset allocation discussions in 2019 is the yield curve, which inverted for the first time since 2007 and can be considered forward-looking.

In this short research note, we will explore using the yield curve to improve allocations to the Value factor (read Factors & Interest Rates).

METHODOLOGY

We focus on the Value factor in the US stock market and source data from the library of Kenneth R. French. The performance of the Value factor is derived from a dollar-neut