Asset Allocation in Bear Markets

Asset Allocations Need to Stay Disciplined to Work

The chart below shows the compound return spread from investing in the Russell 1000 Growth Index less an equal investment in the Russell 1000 Value Index. When the line is above zero, it represents how much a dedicated growth investor has been beating a dedicated value investor since 1989. When the line is below zero, it represents how much a dedicated growth investor has lost to a value investor since 1989. Avoiding outsized exposure to any one equity style-box requires disciplined asset allocation in a what appears to be a sharp bear market in growth stocks.

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Value Stocks vs Growth Stocks’ Historical Performance

Walking through the stages of great growth manias and their inevitable aftermath:

• Stage 1: from 1989 to 2000, growth beat value by 260%, with virtually all of that outperformance happening in the three-year growth bull market mania
• Stage 2: from the stock market’s heady peak in 2000, growth investors saw their money cut in half in just six months while value stood still, and value would continue to pound growth investors into 2007
• Stage 3: from growth’s low point vs. value in 2007, both investment strategies would trade fierce blows for a decade, and by 2017, value investors still held a material advantage over growth investors
• Stage 4: 2017 would mark the beginning of a massive growth bubble that would peak in 2021 on the back of record government stimulus, loose money and the most promotional mutual funds we can recall

This chart updates our work on growth vs. value in 2019. The data in that piece demonstrated that when the returns from growth sharply exceed those of value over three-year stretches, the mean reversion is swift and painful. Stage 5 is that mean reversion in action.

Portfolio Construction Starts With Asset Allocation

Responsible investing is most difficult when it is most valuable and important. As bubbles soar, long-term investment objectives quickly succumb to speculative trading. We do not mean this as a criticism.

These are simply the predispositions of human beings documented over centuries of financial history. As legendary economist John Kenneth Galbraith explained, bull markets and their consequences are as easy to identify as they are difficult to avoid. We are hardwired to make the same mistakes again and again.

We have noticed a lot of pundits suggesting the recent sell-off was an opportunity to buy. Our team believes timing the market is impossible. We don’t engage in forecasting.

We take current market data and frame it in a historical context to help inform the payoff structures based on empirically informed evidence-based research. We offer up the chart below as a simple guidepost of where growth, core, and value indexes are today.

KCRs fund managers have been at this a long time. We have managed money through many a financial crisis. We believe the chart below suggests that the risk/reward for growth may still be skewed to the downside. We continue to maintain a margin of safety across the various portfolios we manage.

As always, we encourage subscribers to engage with us for additional material should they seek deeper and more nuanced context. We spent much of 2020 and 2021 working with our institutional clients studying the empirical evidence around growth, value, and other asset allocation questions.

Penned in June of 2020, our work, 60/40 Asset Allocation: Buying a Ticket on the Titanic, warned that the traditional mix of bonds and equities was dangerous and we offered an alternative solution. While that has obviously panned out, the data continues to suggest that the work is as relevant today as when it was published.

We have written two unorthodox pieces on private equity returns, which built on our earlier research that debt to EBITDA ratios and valuations in the space had become precarious. With that in mind, we updated our 60/40 work in a piece for our sister company, L2 Asset Management.

Titled, The 60/40 Portfolio Crisis, Not All Alts Are Created Equally, the piece explains the opportunity we believe exists in the traditional market-neutral space. As Barron’s reported, in 2010 with equity markets at generational lows based on valuations, hedge funds experienced record inflows. This was one of the worst times to invest in long/short products as markets would rally off record-low valuations for over a decade.

A Morningstar article published in June of 2017 noted that just two liquid alts offered by large companies had seen assets soar to over $3.5 billion. By 2021, just as the bubble was peaking, these two funds had experienced a 90% collapse in assets. Investors abandoned these strategies at the very moment when long/short should have been in favor. As our extensive research has shown, despite the recent sell off, spreads are still nearly as wide as at the peak of the dot.com bubble.

Our team notes that these two funds’ recent nascent inflows may be the beginning of a trend toward more modest return expectations and an emphasis on compounding wealth through capital preservation.

For those looking to explore other venues, we encourage you to review our work published around the peak of the recent mania. Our bear traders post explained the basics of breakeven and the importance of capital preservation. In other work we explained some of the best stocks for a recession. That research was designed to encourage thoughtful reflection while offering potentially simple solutions to a market we feel is among the most challenging we have encountered in our lengthy careers.

KCR also believes that under the guise of low fees, investors are being swept into index funds facing unprecedented headwinds. Our piece on the Vanguard Small Cap Index Fund exposed what we believe to be a serious flaw in small cap index products. Similarly, our Tesla Price to Sales Ratio work identified what we believe is a non-trivial headwind facing large cap index funds.

As the Financial Times recently reported, passive fund ownership of US stocks has overtaken active funds for the first time. We believe this has led to the most crowded asset allocation and stock selection method in history. Our summary of Andrei Shleifer’s Inefficient Markets offered simple examples of the behavioral errors that researchers have documented over decades of work.

With passive management allocating capital blindly, we believe the benefits of employing low-cost and tax-advantaged active management have never been higher than today. As always, our team encourages prudence in a time of uncertainty.