Analysis of the US corporate earnings cycle going back to 1990 suggests there is a now a good access point for investing in the ‘quality’ style of smart beta, says Jonathan White, client portfolio manager at Axa Rosenberg.
Smart beta equity investors typically have long-term expectations for the risk and return behaviour of their chosen investment style. That said, a reasonable question for smart beta investors is how risk premia are expected to perform in light of what is happening in the market. It is a simple question that can be challenging to answer, particularly for newer products that have not yet been tested through different market environments.
While the construction and application of smart beta products is new, many smart beta approaches have evolved from investment principles that have been used in investors’ portfolios for decades. Because of the long history of many of these underlying principles, we can analyse how different smart beta risk premia have performed in different market conditions.
A useful anchor point for such analysis is the corporate earnings cycle. The cyclical performance of different strategies provides investors with a good guide as to which strategies are “all-rounders” that perform reasonably in both bull and bear markets, which provide solid protection on the downside, and which are best positioned to capture maximum market upside.
While no single risk premia performs well at all stages of the cycle, it is possible to observe some consistency in their historical behaviour with respect to the stage of the earnings cycle. Of course, past performance may not be repeated, but such a framework offers important context with regard to performance expectations.
The earnings cycle can be divided into four stages:
a. Earnings expansion - early cycle bull market: earnings are growing rapidly and equity market prices are rising
b. Earnings expansion - mid to late cycle bull market: earnings continue to grow and equity market prices to rise, but the rate of change is steady or slowing
c. Earnings recession - bear market: earnings fall by 20% or more and equity market prices decline
d. Earnings recession - recovery: earnings recession continues, but equity markets rise in anticipation of a recovery
Historical patterns in the performance of risk premia
Looking at the US market going back to 1990 (focusing on just the US to prevent any regional disparities), some interesting trends emerge over the three earnings cycles that have taken place. The four risk premia we have analysed here include: low volatility equity, quality, value and momentum.
Looking at periods of earnings recession, quality, low volatility and momentum perform well in the earnings recession-bear market phase of the cycle, but suffer during the recovery phase. On average, value styles seem to navigate the recession-bear and recovery phases well, but with less consistency. Momentum historically performs well in the earnings recession-bear phase, but significantly underperforms in the recovery phase.
In earnings expansion, low volatility equity, on average, lags the broader market in both the early and mid/late stages– an unsurprising result, as markets are in bull market rally mode. Quality performs more effectively during earnings expansion and historically has become a more important source of return as the cycle matures.
Value generally performs well during periods of earnings expansion. However, a more detailed look at the range of value styles shows that as the earnings expansion cycle matures, book-to-price and dividend yield have historically become less effective. Value, as measured by price-to-recurring earnings, remains effective.
Momentum has historically performed well during the mid/late stage of the earnings expansion phase. Typically, it becomes more effective as the earnings expansion phase matures.
Is the current cycle different?
How does this analysis apply to current market conditions? All cycles are different and the current US earnings cycle has many unique features. For example, short rates are yet to rise and we are now six years past the trough in corporate earnings. By this point, we would have normally expected tightening to be well underway. Given the protracted period of stimulus injected to re-start the US economy following crisis, this earnings expansion phase could end up lasting longer than usual.
From a risk premia perspective, it is worth noting that during this cycle quality performed better than usual in the early phase of earnings expansion and also performed strongly in 2014. Will this potentially hamper the performance of quality as the current cycle matures? We don’t think so because despite its recent strong performance, the valuation of quality still looks reasonable, trading on similar valuations compared to previous cycles.
Time to buy into quality?
This analysis suggests that now is a good time to buy quality for global and US equity investors. Indeed, quality should form a structural part of the portfolio allocation to smart beta, mitigating risk when times are tough and maintaining a connection to growth when times are better.
Other strategies can have drawbacks by comparison. Low volatility may be ideal for providing protection in a bear market, but can underperform for protracted time periods during earnings expansion. Conversely, while momentum and value typically perform well during earnings expansion, the performance of some components of value can wane late cycle.
Why does quality seem to have the twin attributes of defensiveness during recession and solid performance as the earnings cycle matures? We believe this is because quality benefits from a fundamental link to corporate earnings growth and balance sheet strength. As such, in recession, quality is less exposed to balance sheet distress and earnings drawdown than the market. Its importance grows in the latter stages of the earnings expansion phase because it offers exposure to earnings growth that is becoming harder for companies to achieve and for investors to capture.
In the US, we can say with reasonable confidence that we are no longer in the earnings expansion phase of the market cycle because the rate of change in earnings growth has slowed and interest rates are expected to rise. When the Federal Open Markets Committee does eventually start tightening, another significant feature of a maturating earnings cycle will be in place.
While quality should form a strategic allocation for a smart beta investor always, offering protection during bear markets and growth during earnings expansion, in the face of a maturing US earnings cycle, now could be a good entry point for investors not yet allocating to this structurally important risk premia to start doing so.
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