As 2017 comes near to a close, and the stock market by many accounts outperformed analyst projections, a Bank of America Merrill Lynch report on factors notes an interesting change that occurred relative to factors it watches. With 2018 forecast to be another reasonably strong year for US stocks, factor performance is a moving target and is likely to play into market gyrations?
Factor performance: Switch in value and momentum factors towards the end of the year
Looking at the small capitalization universe of stocks, BAML’s Equity Quant Strategists Dan Suzuki and Jimmy Bonilla see a shift in factors.
After being the worst performing factor throughout the year, valuation – stocks that are “inexpensive” on a price basis – have picked up over the last three months, the first such pick up since the fourth quarter of 2016.
Valuation-based factors, such as price to book ratios, make up six of the 10 worst-performing factors this year, BAML notes, but that is starting to change.
The recent switch to valuation factors outperforming comes at the expense of momentum. Momentum factors were among the best performing on the year but were the worst-performing factor group in November. This can be seen as the worst momentum factor performance, the One-Month Change in the 200 Day Moving Average, down 3.2%. Even with the recent loss of momentum, this factor remains the second-best performing factor group year to date. This group is led by stocks with the highest Earnings Surprise, up 10.8%.
Vijay Vaidyanathan, chief executive officer of Optimal Asset Management, an advisor on factor investing to institutional investors with over $700 million under management, notes that value and momentum are often negatively correlated. He says during consistent, low volatility bull markets momentum tends to outperform value. “When there is a market environment with a growing risk appetite and greater dispersion in stocks, value works well,” he said. “Value stocks get hit worst during a market crash, but often are the best values after a crash.”
Factor performance: noncorrelated value and momentum are the place to be in 2018, unless volatility rears its head
While momentum and value faded, the BAML study noted growth was the second-worst performing factor group last month, which Suzuki and Bonilla attributed to a mirroring of the underperformance seen among large caps. “However, Growth still makes up four of the top 10 best-performing factors so far this year, led by stocks with the highest Long-term Growth Rate (+12.8ppt). Growth, along with Low Leverage,
Momentum, and Liquidity.” They call these “the four horseman.” They are the only four factor groups with positive alpha so far this year and are the same four groups that have outperformed during the last 12 months of each of the last three bull market cycles, the report noted.
The outperformance of Liquidity was much less stark on a Q1 relative spread basis (vs. the Russell 2000 universe) than on a Q1/Q5 basis, suggesting that the underperformance of the least liquid stocks drove most of the alpha in November. Meanwhile, Valuation factors performed similarly on a Q1 relative spread basis as they did on a Q1/Q5, suggesting that both cheap and expensive stocks outperformed in November; the cheapest stocks simply outperformed by a greater margin. On the flipside, Momentum factors had much better performance on a Q1 relative spread basis than on a Q1/Q5 basis. This suggests that it was not so much the underperformance of stocks with high momentum that drove the alpha in November, but the outperformance of stocks will the worst momentum.
Small capitalization stocks tend to have wider value dispersion as less attention is paid to them from an institutional research perspective. Vaidyanathan notes that individual stocks have a high degree of idiosyncratic volatility, which in part can occur when the market discovers new information about a small cap stock that was previously unknown. Volatility in factors is slightly different. “Well-constructed factors tend to have little-to-no idiosyncratic volatility,” he said. “Going forward in 2018, Vijay would be in value and momentum, but if volatility starts to pick up he would move into quality and low vol stocks.”