Friday, April 2, 2021

The Value Trade Opportunity - A reduction in the value spread


What is going on with value? The value spread has reached extremes, and this is what will have to close to make higher returns. In simple terms, the value spread is the difference, after a universe of stocks are ranked according to some measure of value, between the overvalued firms (short positions) in the top quintile and the undervalued firms in the bottom quintile (long positions). See "Value Investing: Capitulation or Opportunity?" 

Since 2018, the overvalued stocks became more overvalued and undervalued became more undervalued versus each other and the median. This increase in value spreads has occurred around the world and has matched the speed and intensity of the value spread widening during the tech bubble and to a lesser extent before the GFC. The value spread will vary significantly across market sectors both for COVID sector winners and losers.  



Spread widening and compression is a significant driver of performance. The information ratio for value will increase during periods of value compression and decline during periods of value spread expansion. The link between the spread compression and expansion applies to all long/short factors strategies but the sensitivity of the information ratio seems greatest for the value factor. Return is generated as the cheap (rich) stocks move back to the median valuation. 







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