Financial Advisors

Behavioral Asset Allocation for 2021

The previous year was marked by rapid shifts in market sentiment as investors quickly cycled through a range of behavioral extremes, including fear, panic, hope, and excitement. As an investor specializing in behavioral finance, I recognize that the extraordinary market movements seen in 2020 have made it difficult to determine the optimal positioning for portfolios as we enter 2021. Therefore, in a time when many investors are pondering asset allocations, I wanted to share my thoughts on the broader market landscape and highlight what opportunities and pitfalls investors face going forward.

Do Any Segments of the Market Offer Opportunity?

To objectively examine the degree of opportunity across the spectrum of public equities, the tables below display the Price to Earnings metric for key domestic equity allocation opportunities over nearly two decades of market history. These tables are informative as they provide insight into how attractively or unattractively valued a particular segment of the market is by highlighting how current valuations compare to historical valuations. For example, an index trading well above its historical valuation range would be considered expensive given that companies or market segments typically revert to their long-term valuations over time.

Market segments

The above data first illustrates that elevated valuations are very prevalent as nearly every equity allocation opportunity trade at a substantial premium to historic valuation levels. I would also note that “large” and “growth” related equity styles are trading at particularly extreme premiums to historical valuation ranges. In some cases, the current valuations for these equity styles represent the highest levels seen since the turn of the millennium. However, I would conversely highlight that one equity style does stand out in this environment: small-cap value equities. The small-cap value equity style is starkly differentiated. It is the only group to trade near its long-term median valuation when every other allocation opportunity is trading its extraordinary premiums to historical valuations.

This is a critical observation as we evaluate the level of opportunity in the market as this data shows a significant degree of variation in the valuation of each equity style. Given the importance of valuations in determining long-term returns, this data highlights that many equity styles have reached unsustainable levels. However, the data also indicates that small-cap value equities offer a meaningful opportunity relative to other market segments. In a scenario where valuations simply revert to normalized levels consistent with what has been observed over decades of market history, the small-cap value equity style would meaningfully outperform peers.

Why Have Small Cap Value Equities Become Relatively Undervalued?

While the attractiveness of small-cap value equities is material, the group's compelling positioning is even more notable when considering that "small" and "cheap" companies have historically generated the highest returns over time. This can be seen in the chart below that exhibits the returns of various market segments delineated by capitalization and valuation over approximately seventy years of market history.

Annualized returns by company size

The above return data raises the question of why investors have chased “large” and “growth” companies in recent periods while small-cap value has remained attractively valued. While there are several probable causes behind this phenomenon, the relative undervaluation of small-cap value equities has primarily occurred as investors have become increasingly infatuated with disruptive technologies, intangible assets, and growth at all cost business models. Concurrently, many market participants have come to misunderstand and mischaracterize the businesses that comprise the small-cap value equity style as dying, no-growth businesses that cannot possibly keep up with their “larger” or “growthier” peers.

2019-2022 consensus estimate annualized EPS growth

However, data objectively disproves the notion that the companies comprising the small-cap value equity style are somehow incapable of thriving in the current environment. This can be seen in the table above, displaying the consensus-estimated forward EPS growth rate of every equity allocation opportunity. In particular, small-cap value equities are projected to generate a level of earnings growth that is either similar to or above most other equity styles. Therefore, this data indicates that the attractive relative valuations of the small-cap value equity style result from inefficient investor behavior rather than a justifiable fundamental basis.

Why is Now a Particularly Opportune Time to Shift to Small Cap Value?

Although small value companies have proved to be the strongest performing over time, no segment of the market outperforms all the time. Accordingly, periods in which investors have underappreciated small-cap value equities are not without historical precedent. However, there have only been a handful of instances in the past seven decades where the divergence between small-cap value equities and the rest of the market has reached a level comparable to what is being seen today. This positioning of the market landscape can be seen in the two following charts that display the rolling three-year annualized relative return between “small/cheap” companies, “small/expensive,” and “large/expensive” companies. 

Cheap stocks vs expensive stocks

The data above exhibits that "this time" was not different in each of the handful of historical periods similar to today where small value companies fell out of favor with investors and underperformed. Utilizing history as a guide, periods where small value companies have become negatively disconnected from the broader market have always proved temporary as small-cap value equities have rebounded after every instance of underperformance. With that said, given that the proverbial rubber band has been stretched to such an extreme degree, the future resurgence of small-cap value will likely occur very rapidly. I believe that inefficient investor behavior in the current environment has created an extremely rare and ultimately fleeting opportunity to allocate to small-cap value as we begin 2021 before the equity style once again begins a considerable and lengthy run of outperformance that is consistent with historical levels. 

Any forecasts, figures, opinions, or investment techniques and strategies explained are Hillcrest Asset Management, LLC's as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given, and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment. The material should not be relied upon as containing sufficient information to support any investment decision.

Data is provided by various sources and prepared by Hillcrest Asset Management, LLC and has not been verified or audited by an independent accountant. Test results are not indicative of future results and should not be relied upon. While the information provided above is not based on the performance of any individual security or group of securities, the methodology used to provide the information can be obtained by contacting Hillcrest Asset Management, LLC.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Brian Bruce

Brian is the CEO and Chief Investment Officer of Hillcrest Asset Management. Hillcrest is a pioneer in the application of behavioral finance which it utilizes in managing investments.

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