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JOHN REESE

A contrarian view: The case for buying what hasn’t worked Add to ...

John Reese is chief executive officer of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.

History doesn’t exactly repeat itself, but echoes of the past are all around. In the late 1990s, U.S. markets bested international and emerging markets, buoyed by high flying stocks of young and unproven technology companies. Growth stocks were king.

Of course, we know now what happened. The tech-stock bubble burst and everything was thrown into a wrenching two-year downturn. When the recession was over, value stocks, which had trailed growth-like names during the tech boom, as well as shares of companies in the fast-growth developing markets of Brazil, Russia, India and China took off on a seven-year bull run until the markets got slammed by the bursting of the housing bubble and the financial crisis.

These sharp ups and downs in the market can be attributed to what the contrarian investor guru David Dreman says is the tendency for investors to overreact, and pile into popular stocks while shunning those that have fallen out of favour. The increasingly heavy use of funds that track indexes can exacerbate this because the major indexes are market-cap weighted, and thus funds that track them tend to more heavily invested in certain stocks, pushing their prices artificially higher.

It’s been nearly seven full years since the latest market bull-run started, in the aftermath of the financial crisis.

Mean reversion in the markets is a very powerful force and the next five years could see a resurgence of emerging markets over the developed economies and trends favouring cyclical, value and small cap stocks over defensive, growth and large cap names, and more varied risk-taking.

Start with emerging markets. The iShares exchange-traded fund that tracks the MSCI emerging market index has risen nearly 16 per cent this year through Monday, compared to the 3.7-per-cent gain in the fund tracking the MSCI world index and the 5.8-per-cent gain of the fund tracking the Standard & Poor’s 500. And despite the rise, valuations in many emerging markets are far below those of developed markets.

Global growth trends are supported by central bank monetary policies, and China has shown signs of reversing a recent slump, posting a 7-per-cent gain in gross domestic product in the second quarter. After five years of declines in earnings per share, emerging markets companies are bouncing back, and after Britain’s vote to exit the European Union, emerging-markets funds got a record $14-billion (U.S.) in investor money.

Beyond the emerging markets, the dividend-paying defensive stocks investors favoured at the beginning of the year, and which have become very expensive relative to their historical valuations, have given way to shares of companies in the financial, energy and technology sectors.

With this shift, investors appear to be betting that economic growth has the potential to come in better than expected in the near term, because cyclical companies are sensitive to economic growth trends.

The Powershares high-beta fund is up 13 per cent year-to-date, outpacing the 9.5-per-cent gain in the fund tracking low-volatility stocks.

Energy and financial stocks were beaten down and stand ready to spring back. Rising rates could help give them a boost because financial and energy companies benefit from a strengthening economy and, typically, increasing rates indicate a stable growth economic environment.

Perhaps investors have grown wary of the glamour stocks and overvalued defensive names, and are ready to return to the ways of Benjamin Graham and Warren Buffett, the value investors who have taught us that good businesses make good investments. Value stocks have trailed growth names since the end of 2007 on a cumulative basis. This is one of the longest stretches of growth over value in market history. However, the tide is turning, albeit slowly, and a fund tracking U.S. value stocks is up 7.6 per cent this year, compared to the nearly 4-per-cent increase in the fund tracking growth stocks.

It could be that so many investors piled into defensive and growth stocks that they got overheated, and people are rotating into cyclical and value stocks because that’s where the bargains are.

Speaking of bargains, over the last 11 years U.S. small caps have only been cheaper relative to large caps, based on trailing price-to-earnings, 11.9 per cent of the time. Small caps typically exhibit higher returns over time compared to larger companies, but over the last five to six years the trend has been the opposite, with the Russell 2000 trailing the S&P 500 by more than 25 per cent on a total return basis. I believe part of this is driven by the migration to passive, index-based investing, in combination with a slow growth environment. Small caps are setting up for a nice reversion when growth eventually comes in above expectations.

Over time, market trends tend to be cyclical. We also know that investors, as a collective group, tend to overweight what has happened recently. The outperformance of growth over value, large over small, developed over emerging and defensive over cyclical are trends that have dominated in most of this bull market. However, investors who are extrapolating the performance of these trends out into perpetuity and not understanding the long term data, the nature of risk and return, and why valuations matter may be wishing they had taken a more contrarian view when they had the opportunity to.

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