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This year has been a humbling reminder of the cyclical nature of stock markets. In the UK, small and mid-cap shares have felt the pain of the sell-off more than most. But generally speaking, markets everywhere have come under pressure.
You don’t have to look too far to find the last major decline like this. In early 2020, stocks fell at their fastest rate on record as Covid began to bite. But unlike then - indeed unlike any correction for more than a decade - this time it’s different…
After the financial crisis in 2008/9, central banks pursued a policy of economic stimulus using quantitative easing to lower interest rates and thus suppress the cost of borrowing. Apart from anything else, this created a strong tailwind for stocks. Indeed, extra economic stimulus through Covid was enough to get the market into recovery mode in double quick time.
Fast forward to today, and a decade of easy conditions and economic growth have given way to a different kind of problem: high and rising rates of inflation. With it, central bank policy has been slammed into reverse. Rate hikes are now just about the only tool they’ve got to try and control spiralling prices.
While inflation itself isn’t the only drag on equity prices right now, the market reaction to more hawkish moves by central banks is not really surprising. Growth stocks, which have performed well for years, have been among the first to suffer. But much more broadly, companies are having to deal with, and pass on, rising input prices, which will inevitably damage earnings.
As a result of this, and unlike any other time over more than 10 years, ‘value’ is becoming mainstream again as a criteria for investing. Stocks that just a year ago were on punchy valuations can now be bought much cheaper. The question for investors, of course, is whether they are likely to get any cheaper from here.
This brings us back to the idea of stock market cycles. Twelve years ago, when I started writing articles about screening strategies for Stockopedia, the market was just clawing its way out of the 2008/9 collapse. It was an utterly brutal couple of years.
I remember that one of the things our newly-constructed Guru Screens were screaming at the time was just how cheaply priced shares in house builders were. Sure, there were lots of bargain-priced stocks, but these house builders seemed to be universally unloved and priced accordingly.
In some ways, this wasn’t a surprise because the crisis was closely linked to the housing market and mortgages. But more to the point, the economic chaos and the perceived pressure on consumer spending was taken by the market as very bad news for house construction. But that was wrong.
What followed was a boom for construction firms, propelled by government support in the form of help for new buyers. Over time, their prices moved very closely in step with each other. And whilst they are cyclical and prone to downturns (and they get valued as such), these stocks have still easily outperformed the market and pay solid dividends too.
Today, heightened uncertainty has started with a sell off in consumer cyclical stocks. Retail and leisure shares - especially smaller firms - have been heavily marked down. The latest retail sales figures show that consumers aren’t spending as much. And once again, house builders like Bellway (LON:BWY), Taylor Wimpey (LON:TW.), Redrow (LON:RDW) and Crest Nicholson (LON:CRST) are qualifying for the likes of the Ben Graham NCAV Bargain Screen - a screen look for firms with valuations lower than their net current asset values. Sentiment seems to have gone full circle.
With certain stocks and sectors coming under extreme pressure, the job of the investor is to try and understand what the market is pricing in, and where the opportunities might be. In times of misery, the chance of investor overreaction, of stocks selling off too much, of being dumped in a panic, can lead to mispricing. This is classic value territory - and it’s a very different theme to the one we’ve seen for a decade where investors were prepared to pay high prices for the promise of earnings growth.
But even with the best research, buying stocks in a sell-off comes with the inherent risk of ‘catching falling knives’ (stocks that just keep on falling). Hardened value investors - like Ben Graham himself - aim to avoid this by buying at a big discount to the stock’s intrinsic value (providing a margin of safety).
Another option is to use value and momentum to find cheap stocks that are finding support in the market. We’ve got a couple of screens that use this kind of approach at Stockopedia. One is the Value Momentum screen, which combines a low price-to-earnings growth rate, positive relative strength and the 52-week high. The other is the Josef Lakonishok Momentum screen, which uses the PE ratio, relative strength and earnings surprises.
Value and momentum in combination can pinpoint businesses in a ‘turnaround’ phase, or simply unloved firms that suddenly make sense in the economic conditions. Both these screens compare share prices to earnings as a valuation guide, and want to see recent strength in the share price. That momentum component is important because momentum tends to be the first fatality in a market sell-off. So if you can find it in the right stocks, it can be a useful signal.
Despite being long-term winners, these screens haven’t performed well on a one-year basis because of the turmoil in the market. But what makes them interesting is that they give us a flavour of the types of stocks that have these value and momentum traits - and these are shares that are to an extent resisting downward momentum across the market. Note also that these screens tend to pick up companies that are in takeover situations.
Here’s a snapshot of some of the top results in the Value Momentum screen:
Name | Mkt Cap £m | PEG (TTM) | Price vs 52w High % | Rel Strength % 1y | Sector |
159,657.5 | 0.21 | -6.33 | +27.4 | ||
1,986.9 | 0.40 | -7.66 | +2.63 | ||
3,027.3 | 0.23 | -7.50 | -0.097 | ||
29,850.8 | 0.67 | -8.82 | +11.3 | ||
23,989.4 | 0.84 | -5.05 | +45.8 |
One of the trends in both screens is the prevalence of larger-cap companies. Both tend to exclude the smallest companies, but value and momentum at the moment seems to be most commonly found in larger, healthcare, energy, industrial and defensive sectors.
This very much tallies with what we’ve seen in the overall market, with investors turning away from smaller, speculative growth towards more solid, defensive feeling firms that might be better equipped to handle high rates of inflation (however long that might last) and weather economic headwinds.
Because the market has a much better understanding of mid and large-cap stocks, price discovery for these shares is more efficient. Essentially, the market is more confident at predicting how these shares will perform against the challenges they face - so the share prices are more reliable. Rather than pricing the ‘now’, it’s pricing the ‘future’, and momentum in these stocks suggests there is some confidence in places.
For smaller companies, pricing efficiency is unlikely to be as good. Small cap investors are feeling that pain right now. It’s simply harder to know how smaller companies will perform faced with tough economic challenges. This leads to over-reaction and extreme price moves. At worst it results in panic.
But for those prepared to do their homework and look for signs of value and momentum, a small-cap sell-off can be the prelude to huge opportunities - which is exactly what happened a decade ago.
About Ben Hobson
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Thank you for this Ben. If we do get a recession it will likely be stagflationary; that is with the economy tanking and high inflation. I thought the term "Stagflation" was coined to describe the 1973-75 recession (I learnt just now that if Wikipedia is to believed it was invented by Tory big hitter Iain Macleod in 1965. He was born round the corner from where I live and is buried in the churchyard in the next village. Somehow this quite impresses me). This is the recession that people seem to be reaching for for comparisons. Unfortunately it was almost 50 years ago, so there can't be many current investors who were in the market at that time. It would be interesting to hear their thoughts though.
However George Blakey's "History of the London Stock Market 1945-2007", gives some PE figs for 6th January 1975:
ICI 3.5,
BOC 3.3,
Trusthouse Forte 2.9,
BP 2.6
Lloyds 2.1
Natwest 1.9!
They seem impossibly low but I suppose the message is that bigger stocks could go that low again... or lower, because it's happened once before and small caps could go lower still.
There isn't much that makes any sense to me at the moment, taking £BP which I hold for instance. Just coming off its Covid low on 22nd March 2020 it carried a P/E of 8.46 while on 24th June 2022 it's P/E was at 4.9 - figures which Investor Sentiment might explain. I'll be waiting a while before adding.
Aargh Aitch - I was in the market at that time. The consensus was so gloomy that it was believed we were witnessing the end of capitalism. Prices and PEs were ridiculously low. The reversal, when it came, was epic. It was reported that a group of institutions had decided enough was enough. The market subsequently took off like a rocket and kept going up for several weeks without a break. Painful though things are at present, it can get an awful lot worse.
The 1973-74 crash in the UK was partly caused by the global economic issues but was seriously exacerbated by UK government actions.
Firstly we had a balance of payments crisis, which at the time was believed to be caused by trying to set unrealistic exchange rates. The pound hit $2.65 by the end of 1972, partly in response to Nixon taking the dollar off the gold standard (it was to fall to $1.65 by 1976 when we had to call in the IMF for a bailout). Attempts to maintain the exchange rate collapsed in 1972 and the pound headed downwards. Inflation started to rise quite rapidly, followed by interest rates.
Then the Conservative government of the time turned on the spending taps in order to boost industry. Instead, however, it fuelled a property speculation boom that was largely funded by loosely regulated so-called "secondary banks", who borrowed short and lent long. Inflation continued to rise and exports to drop.
In the middle of this some bright spark in the government decided to impose rent controls on commercial property. The UK entered a bear market in late summer 1973.
Then the combination of loose lending, increasing interest rates and rent controls came home to roost. Speculative property companies couldn't meet their debt obligations and the secondary banks started to fail. The Bank of England had to mount a rescue. The markets dropped another 15% in November 1973.
OPEC doubled the price of oil at Christmas 1973, Heath declared the three day week. The lights went out, and the balance of payments deficit got worse. The miners went on strike for pay that kept up with inflation. By the end of January 1974 the market was off by 40%.
Heath called an election - and lost. Wilson took over as PM at the head of a minority Lab-Lib coalition. Dennis Healy introduced a tax raising budget for the ages and the markets dropped again. They were now down 50%.
The ability of the UK to repay its debts now came into question. The markets carried on in freefall. There was a another election in late 1974, returning a Labour government wth a small majority which reversed the rent control legislation. In December 1974 the market was 73% down from its peak - and shares were trading at unbelievably low levels (not that most people were buying).
It then began the mother of all elastic rebounds. 1975 saw a near doubling of the market. Of course most investors had given up and had put their money in cash or gold. Still, it took until 1984 before the UK market recovered to its 1972 levels.
Some of this was, of course, outside of the control of the UK - the Dow Jones fell 45%, over a similar period. But the problems were compounded by some very specific local mismanagement on the back of an unbalanced and unproductive economy.
One significant difference between then and now is the lack of exchange controls. Back then a UK investor had to invest in the UK because it was illegal to take more than £50 out of the country. Now neither we nor the companies we invest in are constrained in a similar fashion, so we do have a few more tools than our equivalents of fifty years ago.
timarr
Also worth noting that shorting the market in the 70s was very much the province of the professionals - unlike today, when spreadbetting and CFDs are readily available to anyone……..
As a British Expatriate, who spent his last working decade in Germany, I abandoned British equities in favour of German ones. My equity portfolio is in Euros, and was about 130% of its cost price in June, i.e. before the current situation. No doubt that will have changed recently, but may provide an opportunity for buying, as your article implies.
Both the Value Momentum screen and the Josef Lakonishok
Momentum screen produce US stocks which too far worse than UK stocks
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Yep, agreed, Value screening is THE word this year.
Sidenote: To find the screen of Jack Hough's "Value Momentum" screen mentioned above, you won't find it in the Value Guru's window
- it's filed under Momentum, which means clicking the 'more' button at the foot of the Guru's page.
The Top Ranks 'Value Momentum' screen, gives some differing results