Take Care When Approaching Beaten-Down Parts of the Market

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Christine Benz: Hi, I'm Christine Benz from Morningstar.

The recent sell-off has left few assets unscathed, but some pockets of the market have been hit harder than others. Joining me to discuss these areas that have performed worse during the recent market downturn is Alex Bryan. He's Morningstar's director of passive strategies research for North America. Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, let's talk about the pockets of the market that have really borne the brunt of the sell-off, starting with U.S. stocks.

Bryan: In the U.S. stock markets, smaller-cap stocks and value stocks have tended to underperform their large-cap and growth counterparts. If you think about the academic research that suggests over the very long term you would expect small-cap stocks and value stocks to give you higher returns, in this market environment, we've seen the exact opposite, which suggests that there is an element of risk here that a lot of investors have exposure to because a lot of investors are leaning into those stocks in order to boost their expected returns.

Benz: Let's drill into some of the reasons that smaller-cap and value stocks have really born the brunt of this sell-off.

Bryan: A lot of the underperformance for value has to do with some sector biases that a lot of value strategies have. They tend to lean in to sectors like energy, financial services, and industrials that have been hit particularly hard. Energy stocks have been hurt by the price war between Saudi Arabia and Russia. They've also experienced a collapse in demand as people have started staying in more in response to COVID-19. Financial-services stocks have been hurt as interest rates have come down, which has compressed their net interest margins, and industrials of course are very cyclical, so they've been hurt as well.

But on top of all that, a lot of value names were facing somewhat poor business prospects heading into this crisis. So this is just exaggerating some of the problems that a lot of these companies have had, and a lot of them are not as well positioned to weather the storm as some of their faster-growing counterparts. I think that's a big part of why we've seen value underperform.

As far as small caps, a lot of these names tend to be more cyclical to begin with. They are more highly levered to the U.S. economy than some of their larger-cap counterparts. And a lot of them are less likely to have durable competitive advantages, so less cushion, less cash to cushion the blow during this relatively tough time. I think all those things have led to this quite substantial underperformance that we've seen in those areas.

Benz: So that's the U.S. equity market. Let's talk about the bond markets, some areas that have really struggled there.

Bryan: So not surprisingly, credit risk has really, really underperformed. So high-yield bonds have just tanked as credit spreads have blown out. And that's not surprising. We tend to see this anytime there's a risk of a recession that crops up, because the risk of credit downgrades increase, particularly if you think about energy stocks, a lot of those are kind of on the bubble of triple B rated securities and a lot of them are at risk of being downgraded below investment grade.

But we've also seen corporates, investment-grade corporates, substantially underperform as a lot of investors are really moving out of risky assets and loading up on Treasuries, particularly long-term Treasuries. Those have done quite well as interest rates have fallen. So anything with credit risk has really underperformed.

Benz: How should investors respond to this? Should they lean in to this and potentially look at some of these beaten-down areas or retreat from them? What's your advice about how they should approach that question?

Bryan: That's a great question. It's important to keep in mind that these risks that these areas of the market are facing are still very much there. The market isn't making this stuff up. I would be very hesitant to double down on these areas of the market now. I think the best course of action for most investors is to really just stick to a broadly diversified core stock and bond strategy that gives you exposure to these areas in the market, because there will come a time when they recover, but there's always a chance that things can get worse before they get better. So I think the best course is just stick with a broadly diversified fund, don't worry about trying to time your exposure to these areas of the market because they are loaded with risk. But I wouldn't worry about trying to sell out of them now because they've already taken quite a big beating. The best course of action, I guess, is just to not worry about it. Stay diversified. That's your best line of defense.

Benz: And it seems like if you were planning on doing some rebalancing either soon, or later this year, that would naturally lead you to top up some of these areas that have gone down the most.

Bryan: That's right. So if you're looking at rebalancing your portfolio now, you might actually be able to take advantage of some attractive valuations. But again, I wouldn't be overweighting these areas of the market at this stage.

Benz: Alex, always great to get your perspective. Thank you so much for being here.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.

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