Are liquidity and value heading for a rebound?

June 19, 2020 | Expert Perspective

Are liquidity and value heading for a rebound?

Antonio Picca

Antonio Picca
Head of Factor-Based Strategies

What a wild ride we experienced this past March. Headlines such as "largest single day drop ever," "biggest up day since 1933," and "shortest bear market ever," let you know we were in unchartered volatility territory. While navigating these historic movements in the markets, we became especially aware of the affect these market spikes had on common factor signals such as liquidity and value.

By examining the performance of value and liquidity during past distressed market environments, can history be our guide? Did these factors behave in a similar fashion, and how did they fare as markets recovered? Do these learnings offer you opportunities that can help shape your clients' portfolio allocations going forward?

Liquidity factor: Out of favor … for now

Liquidity, a factor new to many, has its premium story tied directly to our current market environment. The idea behind this factor premium is that investors in illiquid assets receive a premium to hold those assets. This premium exists not only within traditional illiquid investments, such as real estate and private equity, but also in less liquid assets, like municipals and fixed income, and, yes, even within less-liquid equities.

Low-dollar volume stocks represent the less-liquid names. As clients move to tamp down risk and raise cash, the liquidity premium reflects an inability to sell such assets during periods of extreme market turmoil. This happened during the first quarter. The result? If a buyer was found, it was often at a steep discount.

As we witnessed a movement to more liquid names, low-volume stocks suffered as a result. The flight to liquidity became even more pronounced after March 9, when the oil market shock triggered a sell-off in the global equity markets. As market liquidity improved slightly, these less-liquid names continued to underperform through the end of the month. Such events highlight how a long-term premium can be collected by buying securities at discounted prices and providing needed liquidity to the market.

What did the 2020 market sell-off mean for the liquidity factor?

Performance discount of less-liquid stocks relative to the broad market

Performance discount of less-liquid stocks relative to the broad market.

Source: Refinitiv Financial Solutions.

Methodology: The data set screened out securities trading less than $2 million average daily dollar volume from the Russell Top 200 Index, Russell Midcap Index, and Russell 2000 Index. Within each size bucket, stocks are sorted on average daily dollar volume. Thirty-three percent of the stocks with the lowest average daily dollar volume within each size bucket are taken and then equally weighted among the three buckets. The data in the chart is representative of the cumulative returns of the portfolio compared to the cumulative returns of the Russell 3000 Index for the time periods shown.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Less-liquid stocks rebounded strongly after the global financial crisis

While the environment remains fluid, Vanguard is currently predicting a two-phase recovery, with business activity leading the way. Even if this does not materialize, the recent "de-risking" environment could create a buying opportunity as investors begin to forecast a recovery and liquidity returns to the market.

History can serve as a guide. Let's look at the historical performance of less-liquid stocks after the global financial crisis to see how the liquidity factor behaved. After less-liquid stocks sold off in early 2009, investors willing to provide liquidity in such an environment were rewarded.

Historical performance of less-liquid stocks after the GFC

Performance discount of less-liquid stocks relative to the broad market

Historical performance of less liquids stocks after the GFC

Source: Refinitiv Financial Solutions.

Methodology: The data set screened out securities trading less than $2 million average daily dollar volume from the Russell Top 200 Index, Russell Midcap Index, and Russell 2000 Index. Within each size bucket, stocks are sorted on average daily dollar volume. Thirty-three percent of the stocks with the lowest average daily dollar volume within each size bucket are taken and then equally weighted among the three buckets. The data in the chart is representative of the cumulative returns of the portfolio compared to the cumulative returns of the Russell 3000 Index for the time periods shown.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Value factor: Cheapest stocks show a significant sell-off

A similar risk-off pattern was even more pronounced in value stocks, as they tend to be more susceptible to economic downturns. Looking at price-to-book, one measure of deep value often associated with riskier stocks, managers were selling out of perceived "riskier value names" as concerns over credit and near-term earnings weighed on prices.

The impact of the 2020 market sell-off on the value factor

Performance discount of value (low price/book) stock relative to the broad market

Performance discount of value (low price/book) stock relative to the broad market

Source: Refinitiv Financial Solutions.

Methodology: The data set screened out securities trading less than $2 million average daily dollar volume from the Russell Top 200 Index, Russell Midcap Index, and Russell 2000 Index. Within each size bucket, stocks are sorted on book-to-market value of equity. Thirty-three percent of the stocks with the highest book-to-market within each size bucket are taken and then equally weighted among the three buckets. The data in the chart is representative of the cumulative returns of the portfolio compared to the cumulative returns of the Russell 3000 Index for the time periods shown.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Will value rally again as it did in 2009?

Assuming we avoid excessive bankruptcies or defaults, long-term earnings will likely be impacted less than what is being priced into the market, and this "de-risking" of portfolios creates potential buying opportunities. Let's look at the historical performance of value stocks after the global financial crisis to see how the value factor rebounded strongly coming out of the market sell-off. While its clear value stocks saw a greater decline than their less-liquid counterparts, they also experienced a much stronger subsequent recovery.

Value stocks rebound sharply after the GFC

Performance discount of value (low price/book) stock relative to the broad market

Performance discount of value (low price/book) stock relative to the broad market

Source: Refinitiv Financial Solutions.

Methodology: The data set screened out securities trading less than $2 million average daily dollar volume from the Russell Top 200 Index, Russell Midcap Index, and Russell 2000 Index. Within each size bucket, stocks are sorted on book-to-market value of equity. Thirty-three percent of the stocks with the highest book-to-market within each size bucket are taken and then equally weighted among the three buckets. The data in the chart is representative of the cumulative returns of the portfolio compared to the cumulative returns of the Russell 3000 Index for the time periods shown.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Barring a large hit to long-term earnings or a deterioration in the credit profile of these smaller, less-liquid firms, we expect long-term investors to potentially profit from providing liquidity to the market through the buying of these assets at discounted prices.