When shopping, most of us compare items, especially for a first time purchase. Sometimes we stick with what we know, because our experiences tell us it will save aggravation and the cost of buying "the right one" next time.
What if you knew the two items performed almost exactly the same over time, and there was a significant price difference right now? Would you stick with what you're familiar with, or would you try buying the substitute, because a friend told you it was a way better deal?
This is where investing gets interesting. On paper, we know we should buy the substitute. When it comes time to make the decision to spend our own money, most of us stick with what we know. The behavioral gets in the way of the quantitative. The art muddies up the science.
Let's look at 3 relationships that have diverged materially - two within equities, one within fixed income - that, in the past, have represented significant opportunities for patient investors.
Stocks: Growth versus Value
Within stocks, there are "value" companies, like banks, consumer staples, and utilities, and there are "growth" companies, like tech, consumer discretionary, and business services. They are all stocks, and as part of an index, they perform similarly over the long run. Look below at growth, in blue, and value, in red, over the past 5 years. Remember growth crushed value in the late 1990s as everyone wanted to get in on tech. I worked at the time for two value managers, and they were pulling their hair out. Value had its day between 2000 and 2002 as the dot com bubble popped. Today, with low interest rates making life difficult for banks, and Covid keeping everyone home and on their computer, growth is hot and value is not. The "FAANG" stocks (Facebook, Amazon, Apple, Netflix and Google) can do no wrong. Except, the cycle never ends, and one day value will be so cheap, and growth so expensive, the divergence will revert.
Stocks: Large versus Small
Let's comparison shop some more, inside stocks again, this time between large cap and small cap. Small cap actually has slightly stronger long term performance than large cap. The rationale being that small caps tend to perform better while the economy is growing, and the economy spends more time growing than contracting. Recently, a big gap between the two has come about. In the below five year chart, large cap is in blue, small cap in red. You can see the divergence start during the downturn in the 2nd half of 2018, and widen throughout 2019. It's like small caps were predicting the recession. Large caps played their part, relatively outperforming as the economy paused and weakened this year. Going forward? If you think the economy will stop getting worse and start improving slowly, it could be a great time to take profits in large cap and move into small caps.
Bonds: Safe versus High Yield
The last disparity I want to show is in the bond world, between safe bonds and risky bonds. What bond is safer than a bond that has the faith and credit of the U.S. Treasury? If you read the newspaper today, in May of 2020, you will see stories about companies filing for bankruptcy. Most rational investors would want the safe, at the expense of the risky.
Today, safe doesn't pay. Literally. After taxes (if the IRS ever goes back to collecting them) and inflation (I'm using 1% inflation to make "safe" seem risky - how times have changed) a safe bond is lucky to be flat year over year.
When business conditions are tough for some companies and borrowing is expensive, investors can lend out capital at 5-10% rates of annual return. There's some risk, sure, but if you own a fund that owns several hundred different high yield bonds, your worry of the one or two companies that default is much less of a worry. You sit back and collect the interest payments. Right now, because of where we are in the economic cycle, everyone wants safe and no one wants risky. Safe is in red, high yield is in blue:
The point of all three of these dynamics is to show that there are cycles, and we can use the historical patterns prudently, to our advantage.