Back to Overview

Equity investment outlook icon
  • December 2020

2020 Equity Investment Outlook: Factor views & technical insights

  • Katrina Price, CAIA, Investment Director; Gregg Thomas, CFA, Director, Investment Strategy; Tom Simon, CFA , FRM, Portfolio Manager; Matt Kyller, CFA Research Manager; David Lundgren, CFA, CMT, Director of Technical Analysis; Brian Hughes, CFA, CMT, Derivatives Strategist

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. FOR PROFESSIONAL OR INSTITUTIONAL INVESTORS ONLY

Thinking rationally about value, growth, and low volatility factors

Thinking rationally about value, growth, and low volatility factors

During the past year, we have frequently fielded questions about whether the valuation and performance spreads between growth and value will mean revert and whether low volatility is too expensive. At the heart of these questions is skepticism about the rationality of market valuations — i.e., are we seeing irrational exuberance in growth and low volatility stocks and irrational pessimism in value stocks? Based on the fundamentals in each of these factors, across regions, we believe that:

  1. Opportunity exists in value, but fundamentals do not offer a clear “buy” signal.
  2. Increasing risk in growth stocks may be cause for concern in some regions.
  3. In regions where low volatility is most expensive, it could offer the most potential to mitigate market drawdowns.

The time for value?

Low price to earnings (P/E) and low price to book (P/B) are two of the most common ways to express value as a factor. Notwithstanding the value rally in the second half of 2019, stocks that look cheap on these metrics continue to look cheap — perhaps for a reason. Value factors like low P/E and low P/B omit any consideration of a company’s debt. And companies screening well on these metrics often employ high balance-sheet leverage, which can make value factors more sensitive to a cyclical slowdown — a risk that may have receded somewhat but has not fully abated. We consistently hear about balance-sheet strength from fundamental managers, who seek to weed out stocks most levered to the risks presented by the current market environment. One approach some adopt is to look to expressions of value that don’t reward companies for leverage such as enterprise value to free cash flow (EV/FCF).

Value strategies also typically rely on mean reversion in a company’s profitability (i.e., below-trend profitability returning to its average). This implies that for a value strategy to work, there needs to be some volatility in company profitability across the market. However, in the past decade we’ve seen the persistence of profitability steadily increase (Figure 1). This structural challenge for value has been especially acute in the US, where not only is the serial correlation of profitability high, but the spread between the most profitable and least profitable companies has also been widest.

Figure 1

Highly profitable firms have defended their competitive advantages

Rank correlations of current profitability vs prior year (%)
Figure 1

PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS . | For illustrative purposes only. | Sources: Wellington Management, FactSet, Barra, MSCI | Proprietary riskfactors developed by Wellington’s Fundamental Factor Team | Chart data: 1991 – 2019

Japan faces a different problem: Profitability is generally lower there and the spread between the most and least profitable companies has historically been narrow. While the spread is still narrow relative to the rest of the world, it has started to widen. In 2013, Prime Minister Shinzo Abe launched a radical program of monetary easing and corporate reform. While monetary easing poses a structural challenge for those value factors dominated by banks (e.g., low P/E and low P/B), structural reforms have incentivized stronger corporate governance. Against this backdrop, the stocks that have outperformed the most have been those associated with higher profitability. We expect this to continue. Pre-Abenomics, this was anything but the norm.

Growth’s persistence

Growth stocks look expensive relative to earnings across most regions. In addition, in the US and emerging markets, top-line revenue growers are demonstrating increased beta. In short, the opportunity for value stocks — mean reversion in corporate profitability — is a risk for growth stocks. This risk is not distributed evenly across regions. In the US, the profitability of growth stocks relative to the broader market has been declining, while the expected profitability implied by stock prices has been increasing (Figure 2, left chart). This disconnect seems unsustainable. In Europe, on the other hand, relative profitability has increased and is only beginning to be reflected in share prices (Figure 2, right chart). As a result, while we are cautious about the ability of growth stocks to continue outperforming broadly, we are more optimistic in Europe, where the fundamentals are stronger. Our main takeaway here is that it may be wise to be very focused on the valuation of growth exposure, especially in the US.

Figure 2

US and Europe: Two different pictures of profitability

Left: US excess CFROI (excess vs market); Right: Europe excess CFROI (excess vs market)
Figure 2

PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS . | CFROI is cash-flow return on investment. For illustrative purposes only. | Sources: Wellington Management, FactSet, Barra | Proprietary risk factors developed by Wellington’s Fundamental Factor Team | Chart data: January 2002 – August 2019

Low volatility: Still worth the price?

Low-volatility investing is starting to look expensive in the US (but not in other regions) and perhaps with good reason: Historically, when low-volatility stocks have been most expensive relative to their earnings, they have also outperformed the most during market drawdowns (Figure 3). Given the ongoing macro uncertainty, it may be understandable that these stocks have been bid up in the region where they have offered the most downside mitigation. The counter to this increased level of downside mitigation in periods of market stress is that there is potentially higher relative drawdown potential in a market recovery. Our approach to the situation is to be increasingly mindful of the sizing of allocations in order to balance risk across exposures.

Figure 3

Low volatility has historically played its role best when it has been expensive

United States (alpha, %)
Figure 3

PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS . | For illustrative purposes only. | Sources: FactSet, MSCI, Wellington Management | Chart data: February 2002 – June 2019

Seeking balance amid turbulence

The macro backdrop has been volatile and there is little reason to expect this to change in the coming year. As a result, we seek to balance risk allocations in an effort to guard against the risk of a slowdown without giving up the potential for participating in a reacceleration. For a core equity portfolio, we think this means maintaining allocations to mean reversion (value and contrarian), trend following (growth and momentum), and risk aversion (quality and low volatility). In order to manage risk in each of these categories, we are mindful of beta and profitability in trend following, of leverage and profitability in mean reversion, and of regional differences across all exposures.

Are the bulls back on track?

Key points

  1. The recent cyclical bear market is showing signs of abating, with market leadership rotating to sectors that tend to outperform in favorable growth and inflation environments.
  2. Semiconductors and other cyclical groups, along with European stocks (particularly banks), may see continued strength in 2020.
  3. While complacency bottoms can be tricky to spot, one may be underway in Europe, where implied near-term volatility for equity markets is muted.

For informational purposes only. Views expressed are those of the authors, based on available information and subject to change, and should not be taken as a recommendation or advice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. Any forward-looking estimates or statements are subject to change and actual results may vary. FOR PROFESSIONAL OR INSTITUTIONAL INVESTORS ONLY

Following a two-year cyclical bear market, we believe global equities are set to resume the secular bull run that began in 2009. Since then, the market has experienced three cyclical pauses, with each rotation from bull to bear market driven by declining market expectations for growth and inflation. During this most recent cycle, amid near-decade lows for US 10-year Treasuries, stable growth stocks and bond proxies — both beneficiaries in a low-growth, low-inflation environment — have meaningfully outperformed.

In the fourth quarter of 2019, however, as global equities approached record highs, leadership began to rotate toward sectors that tend to perform better amid improving growth and inflation outlooks. Semiconductors, for example, whose performance has historically been a reliable leading indicator of market-cycle change, began to see capital flows and relative improvement as early as June and July this year. Following semis’ strong breakout, other cyclical groups have started to shine as well. Capital goods, including machinery, heavy equipment, and building products, have all been climbing the ladder of relative performance.

Of particular note are European banks, which have been hovering around their Global-Financial-Crisis (GFC) lows for the fourth time since 2009, and which are taking steps to improve their relative and absolute trends. Euro area banks are highly levered to growth and inflation, so we see this improvement as another indication of the impending resumption of the bull market.

As for European equities more broadly, we believe the next bull run could significantly alter the technical profile of this market. As Figure 1 shows, the Euro Stoxx 600 Index is breaking out of a 20-year base, suggesting that the region’s era of minimal growth and perpetual deflation may be end-ing. Meanwhile, European equities’ relative global performance trend has experienced a long period of stagnation, potentially setting the stage for a significant upside surprise in 2020.

Figure 1

European equities are potentially sending bullish signals

European equities’ absolute and relative performance
Figure 1

Chart data from January 1990 to June 2019 | Source: Bloomberg. For illustrative purposes only.

While volatility-centric equity troughs (such as 2018’s fourth-quarter selloff) can be headline-grabbing events, marked by widespread panic selling and sentiment extremes, complacency bottoms are typically subtler.

Complacency may be bottoming in Europe

In terms of sentiment, one of the more challenging technical sequences to identify in real time is a complacency bottom. While volatility-centric equity troughs (such as 2018’s fourth-quarter selloff) can be headline-grabbing events, marked by widespread panic selling and sentiment extremes, com-placency bottoms are typically subtler. The troughing process occurs over time, as fundamentals shift and investors find themselves ill-positioned to participate, having moved on to more active areas of the market. Apathy toward future long-term price movements is typically par for the course.

Today, we believe that a complacency bottom is forming for assets tied to inflation, particularly in Europe, and European banks most specifically. To get a sense of how markets are pricing in key themes, it is useful to turn to the derivatives markets to quantify market-implied movements. Figure 2 shows one-year implied volatility for Euro Stoxx 50 (SX5E) and Euro Stoxx Banks (SX7E) since 2010. The chart highlights the complacency being priced into future expectations for these assets, signaling that the market is not yet pricing in this potential trend change. Additionally, the lows being put in by developed market currencies, interest rates, and gold’s implied volatility may be further confirmation of this theme. Over time, as complacency bottoms resolve, sentiment shifts from apathy to hope and, eventually, to optimism. In our view, the low level of future price volatility forecast by derivatives implies that the market is behind the curve on this trend.

Figure 2

All quiet on the Euro front?

European equities 1-year implied volatility
Figure 2

Chart data from January 2010 through January 2019 | Source: Bloomberg. For illustrative purposes only.

Back to Overview
Alternatives Outlook