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These Terms of Use ("Terms of Use") are made between the undersigned user ("you") and Lord, Abbett & Co. ("we" or "us"). They become effective on the date that you electronically execute these Terms of Use ("Effective Date").

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Market View

In a post-QE market environment, "safety" stocks may continue to benefit from investor demand.

Investment researchers have long recognized that different factors, such as market capitalization or style (value or growth), can affect the performance of many stocks at the same time. Historically, investors could gain exposure to these factors by choosing actively managed portfolios, which potentially could tilt toward these well-known factors. More recently, the proliferation of “smart beta” strategies has enabled investors to access more reliably the return profiles associated with a variety of factors.

In the post–quantitative easing (QE) environment, exposure to several different factors has produced attractive returns, as the U.S. equity market has become more volatile—specifically, those stocks with characteristics such as low volatility, high quality, and high or growing dividend yields. These more broadly can be classified as “safety” stocks. Such stocks typically outperform during periods of market turmoil, declining less on average than the broader market. In addition, many of these stocks tend to generate higher levels of income through dividend payouts, which has become attractive to certain investors, as yields on many fixed-income securities remain historically low. Finally, recent enthusiasm is in no small part due to the ability of recently launched smart beta funds to funnel the flow of investor funds directly into safety securities.

The excellent performance and rising valuations of many of these safety stocks, however, has caused some concern about the future viability of these strategies. Rob Arnott, one of the founders of smart beta at Research Associates, has generated a great deal of industry attention by questioning the current valuations of some popular safety-oriented smart beta strategies. As illustrated in Chart 1, he measures valuations of low volatility to be near historical extremes. In Chart 2, his measurements of relative valuation in high-quality stocks (a related but certainly not identical concept) show them to be in line with historical averages, coming off a period of historical cheapness. In both cases, what is apparent is that the performance cycles of these factors are quite long, often decades.

 

Chart 1. Valuations of Low-Volatility Stocks Are at Historically High Levels
Valuation and relative performance of smart beta low-volatility strategies

Source: Research Affiliates, LLC, using data from CRSP/Compustat. Performance quoted represents past performance. Past performance is not a reliable indicator or a guarantee of future results. The historical data shown in the chart are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Chart 2. High-Quality Stocks Are Coming Off a Period of Historical Cheapness
Valuation and relative performance of smart beta high-quality strategies

Source: Research Affiliates, LLC, using data from CRSP/Compustat. Performance quoted represents past performance. Past performance is not a reliable indicator or a guarantee of future results. The historical data shown in the chart are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Research by Ned Davis, specifically on the performance cycle of high-quality stocks, comes to a similar conclusion. Chart 3 shows that we are, indeed, coming off a period of underperformance by quality stocks. But the mean reversion of these cycles occurs over very long periods, sometimes taking decades to play out.

 

Chart 3. Reversion to the Mean Occurs Over Very Long Periods
High-quality/low-quality ratio mean reversion

Source: Ned Davis Research. Daily data 09/26/1983–05/27/2016 (log scale). Performance quoted represents past performance. Past performance is not a reliable indicator or a guarantee of future results.

 

We expect this post–QE market environment of lower yields and higher volatility to persist, so the drivers of outperformance for safety stocks should remain in place, and that, as such, there’s little reason to expect that investor demand for safety stocks will abate in the near term. While it’s true that these stocks are, in some cases, expensive relative to history, we nevertheless believe that some premium to historical levels is justified. These stocks provide bond-like characteristics—i.e., they are dampening portfolio volatility and providing income in a time of historically low bond yields.

Looking at these stocks as sources of growth and income reveals them to be attractive relative to the traditional fixed-income universe, despite the stocks’ recent runs. In the case of many quality stocks, the yield advantages are sustainable and the stocks offer the potential of long-term growth in payout, a characteristic that should keep volatility in check.

While we believe the broad category of safety stocks merits long-term allocations, it also is our view that investors should be selective in this space. The price paid for an investment is always important—a truism that many rules-based investment strategies are not able to address and that some actively managed strategies have chosen to ignore. We believe that investors would be well served by being mindful of valuation when allocating to safety stocks.

Warren Buffet’s observation that “only when the tide goes out do you discover who's been swimming naked” may well apply here. While we believe the need for both income and volatility reduction will continue to drive returns for these stocks, there naturally will be a time when safety factors go out of favor, and the prices paid for these securities will be an important determinant of their performance. A skilled and seasoned manager focused on the price paid for safety is in a unique position to add value through such times.

 

MARKET VIEW PDFs


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