Why Equity Investors Should Remain Wary of Market Extremes

  • The relationship between the value and sentiment investment themes have reached an extreme not seen since the Global Financial Crisis and the dot-com bubble.
  • Last month, we warned that these extremes could revert to more normal levels; a sharp reversal in expensive stocks with strong sentiment in the first week in September reinforces that warning.

In last month’s commentary, we discussed the extreme relationship between the value and sentiment themes in equity markets, and we warned investors to be wary of reversals in such extreme situations.

The start of September has brought about a reversal in the themes that had been driving some of these extremes, just as we had warned.

Last month, we discussed market concentration in the most extreme expensive and high sentiment pocket of the market; this is the very group of companies that experienced a sharp setback in the first week of September. If we look at the 25 largest companies in the MSCI World Index (see Figure 1), the companies in the top left of this chart – the most expensive stocks with the strongest sentiment – have experienced an average return of -10.6% between August 31 and September 8, while the others have returned -2.5%.

The magnitude of the sell-off in these stocks highlights the risk of investing at times when relationships between themes such as value and sentiment are extremely stretched. It also cautions against having too much concentrated exposure in companies exhibiting these extreme characteristics. In this case, the cross-sectional correlation between value and sentiment was at its lowest level in two decades.

The Bottom Line

We recommend seeking opportunities beyond the concentrated mega caps where more reasonable valuations can be found, with improvements in fundamentals, positive sentiment, and stronger quality characteristics. We see those opportunities in technology, healthcare, telecoms and financials.