As always, John Hussman’s weekly market comment is a must read. In it he discusses what he sees as the driver of returns since QE2 was announced (essentially a transient psychological effect), the asset classes that have benefited and current valuation levels. All three areas are worthy of reading and further introspection but I will focus on the second.
As someone who usually approaches investing from a contrarian value standpoint I found the following analysis extremely useful as I position my investments for 2011.
Ned Davis Research tracks a set of “factor attribution” portfolios, which measure the performance between the top 10% of stocks ranked by a given factor, and the bottom 10% of stocks as ranked by that factor. The factors are things like market beta, dividend yield, 26-week momentum, and so forth. Essentially, the these factor portfolios track the return of hypothetical portfolios that are long the top 10% and short the bottom 10% of stocks based on any given variable.
The performance of these 133 factor portfolios over the past 13 weeks offers tremendous insight into the extent to which the Federal Reserve has encouraged speculative risk. Investors are chasing stocks with the greatest exposure to market fluctuations, commodities, credit risk, small-cap risk and volatility. Conversely, securities demonstrating reasonable valuation, stability, quality, or payout have been virtually abandoned by investors. Here is a sampling (emphasis mine):
|FACTOR||FACTOR GROUPING||13-WEEK RETURN|
|Raw Materials Beta||Commodity Sensitivity||17.47%|
|Credit Spread Beta||Macro Economic Sensitivity||14.66%|
|Small vs. Large Beta||Style Sensitivity||12.54%|
|Silver Beta||Commodity Sensitivity||10.87%|
|Sigma Risk (Volatility)||Risk||10.73%|
|Operating Cash Flow Yield||Valuation||-4.02%|
|Value vs. Growth Beta||Style Sensitivity||-5.87%|
|Return on Invested Capital||Profitability||-6.61%|
|10-Year T-Note Beta||Macro Economic Sensitivity||-9.55%|
|High vs. Low Quality Beta||Style Sensitivity||-15.70%|
The problem with this outcome is that the speculative factors being rewarded over the short-term have nothing to do with the characteristics that have historically been rewarded over the long-term. Despite various periods where valuation is out-of-favor, value has been the clear winner over time. Moreover, it has been destructive to discard valuation in preference for chasing momentum and relative strength after the fact. In contrast, chasing high beta or momentum has conferred no durable benefit for investors. Here is a sampling of 10-year factor returns:
|FACTOR||FACTOR GROUPING||520 WEEK RETURN|
|Operating Cash Flow Yield||Valuation||20.26%|
|Sales / Price||Valuation||19.68%|
|Market Cap||Liquidity and Size||19.10%|
|EBIT / Enterprise Value||Valuation||15.00%|
|Free Cash Flow / Enterprise Value||Valuation||10.49%|
|Silver Beta||Commodity Sensitivity||-1.04%|
Essentially,the QE2 rally has been one of high beta, cyclical and smaller names with valuation, quality and profitability strategies under-performing. However, over time the valuation focused factors have performed favorably.
Contrarians take note; high quality, value based strategies should be priced to outperform their lower quality and higher beta brethren.