The federal government is going to be purchasing corporate bonds directly. So expect that to pop in the near term. However, fundamentally, there is still a huge amount of risk in those bonds.
During the Great Depression, small value (which had been down by 85% according to some measures) bounced back within a few years. That implies a huge upside for small value once the dust settles.
I’ve reached the same conclusion - thinking about the next “regime”. In the meantime, I’d like to make income while this market cycles up/down. I am looking for opinions and/or input on the following:
Background
I am testing a screen “BT MegaCap Options during CY20" (visibility = public) for large companies, not overvalued, low debt, ample cash flow, limited volatility, very limited downside based on historical backtesting (08/01/2007 – 03/06/2009, 7/1/2015 – 09/01/2016, 01/01/2020 – 03/29/2020), etc. I would have no issue owning these companies, but don’t want a repeat of 2008.
I’m limiting to a max. of 10 positions and plan to sell weekly put options (manually verifying, but wish P123 had a way to incorporate into the screen) due to what I anticipate is going to be volatile for some period. Basically, a flat line over time with enough (4-5) tickers per week.
The screen should give you an idea of what I’m trying to accomplish (inactive/active rules). I’d appreciate specific feedback on the screen (not philosophical on strategy, but practical on rules) and if there are other screens that are better or would augment this.
Appreciate your thoughts.
/brandon
I’d like to hope so! But let’s take a look at some of the reasons people have given for small value underperforming: low interest rates, low inflation, tons of dumb money sloshing around the markets, value factors having been arbitraged away, the boom in cap-weighted index funds. In the post-vaccine regime, will any of those be different?
[quote]
I’d like to hope so! But let’s take a look at some of the reasons people have given for small value underperforming: low interest rates, low inflation, tons of dumb money sloshing around the markets, value factors having been arbitraged away, the boom in cap-weighted index funds. In the post-vaccine regime, will any of those be different?
[/quote]Who are these people? Where were these people a few years ago predicting large cap outperformance? Why should (1) low interest benefit large growth (that don’t need to borrow) more than small value (which need to borrow). Why should low inflation (2) help lg? Dumb money (3) chases past performance, but why was past performance of large growth so good? When will the dumb money chase small value? If value factors have been arbitaged away (4), how does that explain the factor reversal of value factors (where higher ranks made progressively lower returns), shouldn’t arbitrage make the ranking system backtest flat? How did the boom in index funds (5) create a bubble?
I consider people who have predicted all this in advance more credible than those who try to make sense of what happened after the fact and try to push a narrative. Ken Fisher is on record as predicting large growth outperformance a few years ago. He nailed it.
Largely because of Ken’s influence, I predicted long term large cap outperformace back in 2012 (not because he called it then, but I applied his principles). You don’t find me making too many market calls because there is high uncertainty, so when I do make a prediction I like to be right. I predicted the bottom in Spring 2009 back in November of 2008, and again I confirmed it in 2009 the day after it happened. I called for large cap performance back in 2012, and I called the bottom in 2018 the day after it happened. Unfortunately, I didn’t call the 2011, 2018, or 2020 tops, and my clients took a hit. I have had more success calling bottoms.
Here is my 2020 prediction. Small value, and in particular Asian small cap value, is highly likely to rebound much faster than large caps once this market bottoms.
Why?
My theory is that two factors drive relative performance: (1) fundamentals and (2) momentum.
(1) Fundamentals come in two flavors (1a) risk and (1b) reward. Fundamentals risk (1a) is the business quality. It includes factors such as growth, financial strength, ROE, etc. Reward (1b) is valuation; as defined by the price paid vs. the future cash flow of the business.
(2) Momentum (i.e. “dumb money”) also comes in two flavors, past risk 2a, (volatility) and past reward (2b).
Why did I call it in 2012? Why am I calling it now?
In 2012, valuations (1b) and business quality (1b) favored large caps, but past performance (2) still favored small value. Starting about 2014, the favorable large growth fundamentals started propelling large growth ahead of small value. Once the market volatility in 2011, 2015, and 2018 exposed more price volatility in small value over large growth, large growth looked favorably from a past risk (2a) point of view, and finally from a past reward (2b) point of view. At that point large growth had all four factors going for it.
Then, in 2018, the new tax laws boosted earnings of large growth (think repatriating foreign earnings). Enter the “dumb money” in 2019 chasing large growth and propelling large growth past small value and beyond reasonable valuations. Now, in 2020, the very real risk of bankruptcy to many small caps is pushing valuations of small value even further down. Once analysts are able to quantify the bankruptcy risk of various stocks, I expect small cap value to bounce back in a big way. In particular, small cap value in countries such as Korea, Singapore, and Japan that started with lower valuations and are coping relatively well with COVID-19 have the best fundamentals (1a and 1b) right now, and should start to see past outperformance which will attract 2, dumb money (i.e. past performance chasers).
I really really really would like to see international data be implemented in time to ride the current regime of Asian stocks!
Are we missing the trees for the forest?
Sure shutting down a company for 3-6 months will affect the company. How much? Maybe less than you think if you use the DDM or discounted cash flow. Maybe you can get a ballpark number on that. Maybe the stock—and the economy as a whole–will be impacted less than you would think.
There will eventually be companies—of all sizes—handing out dividends big enough that you would be a fool not to buy their stock no matter what theology you follow.
Still something is going on with small-cap value. The forest is different—there has been a change no matter what you want to call it.
I would add to the above possible reasons: barriers to entry and the government bailouts. Try to start your own manufacturing company to compete with Boeing (barriers to entry). Try to get the same guarantees from the US government and the Fed that your small business will still be here in 6 months and that you will not have some competition from some other startup if you are (government bailouts and barriers to entry). Try to get the Fed to buy your corporate bonds and imply that it may even buy your stocks to keep you in business (uhhh, crony capitalism).
Maybe someone kept track better than I did on who got bailed out in 2008 and 2009. But that was the past. Now we are told out front that they will do “Whatever it takes.” Whatever it takes if you are too big to fail, live in the right congressional district or are in an important industry that has a large barrier to entry.
For whatever reasons (good and bad) we are not going to let Boeing fail and see if Mark Cuban wants to start an aerospace manufacturing business.
I think I will be with large-caps for a while. Probably too long. Someone will have the common sense to pay $5.00 for an equity with an annual dividend of $1.00 (no matter its size) before I do.
Best,
Jim
A few of these questions are ones that I’d like to have an answer to too. In the context of the models for this site specifically the reversal of value factors and what triggered it I think should be a critical question for those who have used the small cap models developed on this site. I don’t know about you guys but the dependable small cap models I had followed for years could no longer be tweaked to produce a positive result in 2019. Instead quality factors were the flavor of the day. The change was pretty abrupt from what I could tell. What changed? I don’t know and I had to take a break as a result. Does anyone have an explanation?
Taking a step back though and looking at the broader market, explaining the outperformance of large caps I think is easier. Business cycle theory should explain some of it. Also the phenomenon behind the rise of the 1% in comparison to the 99% is the same in the stock market. A few large companies are capturing the bulk of growth in the economy.
I think small caps have significant competitive disadvantages
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shutting down a company for 3-6 months will affect the company. How much?
[/quote]Ummm…Bankruptcy?[quote]
I think I will be with large-caps for a while. Probably too long.
[/quote]You are not the only one who behaves this way. Hence, style momentum. My background is value investing and I don’t mind being early if the reward is great enough and the risk is negligible. It worked for me during the GFC.[quote]
I think small caps have significant competitive disadvantages
[/quote]They always did. Yet small caps have outperformed by about 1% a year over the long term. So that doesn’t explain recent large cap outperformance.[quote]
the dependable small cap models I had followed for years could no longer be tweaked to produce a positive result in 2019. Instead quality factors were the flavor of the day. The change was pretty abrupt from what I could tell. What changed?
[/quote]Ken Fisher predicted that quality would outperform. I have been around long enough to remember a similar factor reversal in 2007 (at the start of the GFC). I have been anticipating a bear market this year but not this fast.
Chaim, this is a fascinating discussion indeed. Do you have any links to the Ken Fisher writings you’re talking about?
Unfortunately, most of Ken Fishers research is being drowned out by negative publicity that he got himself into, and I am having a hard time finding links. Furthermore, in general he has been correct about 60% of the time, which, while being a far better track record than most “gurus”, means that his recommendations are not always actionable out of context.
Having said that, his reasoning a few years ago was that the latter stages of bull markets are generally dominated by momentum.
I can think of another reason why value is doing poorly.
Disruption.
In the age of disruption, companies have shorter lifespans (google source I believe the average lifespan of a company has gone from 45 years to 20 years). A company that is only around for 20 years… if you are already year 10. There isn’t that much cash flow left to milk before it becomes obsolete, gone, bankrupt. Think of it as growth : 21yo rookie draft pick vs value: 35 year old star who is on the decline.
A 21 year old would have the whole growth phase (til 32 years plus the whole value phase of cash flows remaining).
Whereas value stocks in the past don’t just go away easily. They can deliver steady cash flow for decades.
Not sure if this is a good analogy. Just you have to start using negative terminal growth rates instead of positive ones.
Charles,
I agree.
I have read serious discussions that this is one reason Warren Buffett does well. He generally picks companies that have been around for a long time and will probably continue to exist for as long (on average).
And, as you say this definitely affects your cash flow calculations.
Best,
Jim